Stock Traders Ignore Bond Market Signals as Wall Street Mystery Deepens

The fixed-income market's spotless record of striking fear into the hearts of equities dealers is in jeopardy. Stock investors are barely shrugging as two- and 10-year Treasury yields rise for the sixth week in a row, and cash distributions are at or above the S&P 500's earnings yield. Leading American stock indexes have just delivered their greatest monthly gain in a month, culminating Friday with a Nasdaq 100 gain that surpassed any since early February.

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Why peace has broken out in risky assets during a week that saw rates in the whole Treasury market soar beyond 4% is a puzzle for which Wall Street has no obvious answer. Charts might be one reason: the S&P 500 rebounded quickly after dipping below its 200-day average on Wednesday. Another possibility is that investors are misinterpreting rising rates as a hint that solid economic data will continue, according to Chris Zaccarelli of Independent Advisor Alliance LLC.

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"It's amazing to see equities whistle through the cemetery," Zaccarelli added. "Stock investors may be expecting for yields to fall as an indication of a recession and are getting an all-clear in the sense that rates are higher."

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When the week came to a close, the markets displayed an especially striking lack of concern for disaster. The Cboe Volatility Index fell below 19 on Friday as a result of the S&P 500's 1.6% rise, challenging lows reached during the year's early stock market rally. A measure of underperforming technology businesses soared over 6%, while a basket of the most shorted stocks increased 3.2%, marking its sixth straight gain. Even as risk-free returns hit multi-year highs and money flows out of stock-focused ETFs and into fixed-income funds, it is taking place. When rates on short-dated Treasury notes rise above 5%, they are luring investors away from other investments like the classic 60/40 stock and bond portfolio and S&P 500 company earnings.

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Although the transaction is advertised as risk-free, there are opportunity costs. For some money managers, it seems risky to try to get a 5% income while the S&P 500 is in a bear market. Robert Tipp, the chief investment strategist at PGIM Fixed Income, asserted that the short rate wouldn't stay at these levels indefinitely and will eventually fall. "Long-term investments outperform cash, as we have observed over extended periods. And there is no reason to doubt that will be the case.

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The SPDR 1-3 Month T-Bill Exchange-Traded Fund (BIL) has gained roughly 2% over the past year, compared to a 6.3% total return decline for the SPDR S&P 500 ETF Trust (SPY). BIL, meanwhile, has been flat over the previous ten years while SPY has increased 165% over a historic bull run.

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It's a place where you may get paid while you wait, but there isn't long-term price potential like in shares, so there is far less "opportunity cost" than what we're used to, according to Liz Young, head of the investment strategy at SoFi. Thus, "you still need stocks in the portfolio to set you up for compounding gains for folks with more than a five-year time horizon."

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The possibility that rates are nearing their top has investors advising prudence when it comes to buying bonds. While traders have been betting in recent weeks that the Fed would eventually need to hike rates beyond 5% to combat inflation, driving yields across the Treasury curve, they now expect the Fed to stop raising rates by September.

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Tipp recalled the 1970s when inflation threatened both stocks and bonds. Equities increased when growth paused and interest rates leveled out and then fell, despite the fact that the economy remained weak.

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"There's a strong probability that sort of cyclicality will make its way through the markets, and individuals who lock in at the short term, abandon the long-term markets, and move into the short term will suffer," he warned. "Their long-term profits will be smaller since cash rates will almost certainly fall."

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According to analysts, the haven appeal of cash-like positions mixed with predictable returns provides investors with an appealing spot to wait out any volatility caused by the Fed's approach.

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"I do believe that we need to take advantage of the higher rates on the short end of the yield curve as we wait out the prolonged volatility," said David Spika, president, and chief investment officer of GuideStone Capital Management, in an interview. "And then we'll reach a bottom at some point, and that will be a perfect moment to re-risk, take that money out of cash, put it back in stocks, and you'll gain from that."

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Six-month Treasury bonds presently yield 5.1%, the highest since 2007, compared to the S&P 500 earnings yield of 5.3%. This is the stocks' smallest advantage since 2001.

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Though bonds appear appealing in terms of current yields relative to stocks, the risk investors take in allocating to cash is the unpredictability of that yield in the future, according to Josh Emanuel, chief investment officer at Wilshire, which manages over $90 billion.

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"Thus, cash may give you 4.5-5% today, but in a year or two years, that may not be the case," he explained in an interview. "The challenge with allocating to cash is that, while you're not taking any duration risk or credit risk, you are taking the opportunity cost or the uncertainty risk associated with what that cash will pay you in the future relative to the yield you can lock in over the longer term by moving out further on the yield curve."

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