A key indicator suggests the three-year bear market in bonds is about to end, but the transition from a bear to a bull might not be easy since it could occur through a powerful selling climax. If it did, it would help the FED achieve higher rates without having to do anything. But it could also trigger banking problems and be devastating for stocks.
Before we address this, let’s first review a few fundamental things about bonds and how they relate to interest rates and to stocks.
Bond Prices and Interest Rates
Bond prices and interest rates go in opposite directions, so their charts are mirror images of each other. When rates go up, bond prices go down, and vice versa. The graph below shows this mirror image, which comes from the mathematical equations used to calculate bond prices. Since bonds are long-term investments, this inverse correlation is closest with long-term interest rates.
This chart graphs 30-year treasury rates against the price of long-term treasury bonds. We use the treasury ETF TLT as the price proxy for long-term bonds. It graphically shows the inverse, or mirror image relationship between bond prices and interest rates. When rates go up, bond prices go down, and vice versa. This means when investors or advisors are bullish on bonds, they expect interest rates to decline. When they’re bearish on bonds, they expect interest rates to rise. This inverse relationship is built into the mathematical equations that are used to calculate bond prices.
Bonds Before Stocks
The relationship of bonds with stocks is a little more complicated. Since stocks are really bonds in disguise as this article explains, this similarity links their price action. The relationship can be expressed simply as “bonds before stocks.” This means bond prices move before stock prices.
While this statement is generally true, it’s not useful as a timing mechanism. Stock prices have followed bonds up or down with a delay of as little as a month, but sometimes the delay has been one or two years, or even longer.
The chart below shows what I mean. It graphs the percentage price change of long-term treasury bonds and the S&P 500 since 2018.
This chart graphs the percent change of treasury bond prices versus the S&P 500 since 2018. We use two ETFs as proxies for bond and stock prices (SPY for stocks and LTL for long-term bonds). It’s a general principle that bond prices lead stock prices but the time correlation is generally not good enough to be a useful trading tool. Sometimes bonds prices lead stocks by one or two months, at other times they’re ahead of stocks by two or three years.
The red curve shows the 3.5-year bear market in bonds. Bond prices reached a peak in August 2020, yet the stock market continued up for another year and a half before it finally peaked in December 2021. Since that peak stocks have been in a large trading range which we don’t believe is complete. We circled a shorter period in 2018 when the lead time was about three months.
However, we think bonds and stocks are at one of those unique moments when the statement “bonds before stocks” can be predictive and useful. A key indicator suggests we’re approaching a critical moment for bonds. The indicator points to the end of the three and a half year bear market in bonds, and we believe, a final declining wave in the stock market.
A Key Survey Points to Lower Interest Rates and Higher Bond Prices
The indicator is the Hulbert survey of bond newsletter writers. In our experience, this survey is the best gauge for forecasting bond prices. It acts as a contrary opinion indicator, like newsletter writer surveys do for the stock market. It’s bearish for bonds when too many writers expect higher bond prices, and bullish for bonds when too many expect lower bond prices.
We’ve investigated other types of indicators that work well for stocks, like the COT data for bond futures and “puts to calls” ratios of large bond ETFs, but none work as well as this survey at forecasting bond prices. It’s shown below.
This is the SK ranking of the Hulbert Bond Survey. We take Hulbert’s daily surveys, convert them to long-term indicators using a moving average, then plot the values on the red-green Sentiment King ranking scale. Green Zone readings represent extreme bearish sentiment, which is bullish for bonds. Red Zone readings are bearish for bonds.
As the chart shows the bond survey is currently in the green zone. While it can’t tell us if this signals the end of the bear market, or a temporary bear market rally as it has indicated before, we tend to believe it signals the end of the bear market. That’s because, as the chart clearly shows, it’s occurring after prices have formed three, distinct selling waves. It’s an old saw that major price movements end after three waves.
Selling Climax or Soft Landing?
As we explained, we thoroughly believe the three and a half year bond bear market is about to end; the only question is “how.” Will prices slowly turn around and begin to rise as long-term rates slowly begin to decline? Or will it end in a selling climax as we’ve diagrammed below?
This is a graphic of what a selling climax would look like if the bond bear market ended that way.
Selling “climaxes” is a well-known phenomenon in financial markets. They’ve been observed as far back as the 1800s and even earlier. They’re generally the result of a final liquidation cycle of heavily margined positions as traders rush to get ahead of one another to sell.
We think a powerful selling wave could carry interest rates over 6% and bond prices down over 20% in just a few weeks.
Once they’re done, prices generally rebound as new traders rush in and buy the bargains. If this is how the bear market in bonds is about to end, a severe sell-off in stocks would follow.
The one thing we’re pretty sure of is that either event – a soft turnaround or a selling climax – is just around the corner. This is not some far off thing; the transition from bear market to bull market in bonds should occur before the end of the year.