Back in February, I wrote about the 10-year treasury and how jumps of two percent or more had been a bad sign for the stock market. Because the rate has jumped in five of the last six weeks, the 10-year is on the cusp of another two-percent jump.
The chart below shows three instances where we saw big jumps in the interest rate. The first one was from October ’98 through January ’00. That was a jump of 2.722%. The second one was from June ’03 until June ’07. That was a jump of 2.242%. The third one didn’t quite reach 2%, but it was from December ’08 until April ’10 and it was an increase of 1.977%.
The red line is at 3.336% and that represents where the rate would need to get to for it to be 2% higher than the low of 1.336% in July ’16. If we get another week or two where the rates rise and the bonds fall, we will reach the red line.
The bond markets were closed on Monday for Columbus Day, so the chart represents the action as of Friday, October 5.
Looking at the instances marked on the chart of the 10-year, only looking at the S&P 500, we see that it has been a bad omen once the rate jumped over 2%. Even the one in 2008 to 2010 caused a hiccup where the S&P lost 7.7% in just a few months. The ones that ended in 2000 and 2007 came just ahead of the two most recent bear markets.
Looking at the periods more closely, it wasn’t when the magic number of 2% was reached that the stock market turned south. It was when the interest rate peaked and then started turning lower that was the real caution sign for stocks.
Why is this?
I think there are a couple of reasons why such a spike in interest rates is bad for stocks. First, if the 10-year treasury jumps by 2%, that means corporate borrowing costs are rising sharply as well. Treasuries are considered to be among the least risky investments.
Corporate bonds, even the ones with AAA ratings, are considered riskier and therefore have to offer considerably higher rates to attract investors. If growth companies are issuing debt and the borrowing costs have risen by more than 2%, that means borrowing costs are considerably higher and that can cut into profits.
Secondly, when the 10-year rates reach a level that is high enough, it will draw investors away from stocks. Dividend paying stocks aren’t as attractive when interest rates on treasuries reach a high enough level.
Investors that are seeking income off of their investments rather than growth have been starving for decent yields and have undoubtedly been investing more in stocks than they usually would. If the bond yields reach a high enough level, income investors will look to shift assets out of dividend paying stocks and back into bonds. When that happens, that will drive bond prices up and the yield will in turn start to fall. Don’t be surprised if the asset shift doesn’t also mark a top in the stock market.
I hate to keep writing about warning signs for the market, but I believe it is just as important to protect your investments as it is to grow your investments. Some analysts talk about stocks that you will want to “own forever.” I have yet to see a stock that I wanted to own forever and I have been analyzing the market for almost 30 years now.
Even the best stocks will fall if/when we see the next bear market. Sure there will be some stocks that go up, but the vast majority of stocks move with the market. And if we see a drop of 40 to 50% like we have seen in the last two bear markets, you will want to have very little allocated to stocks when the bearish cycle hits.