It’s All About Bonds For Now

This morning, the markets decided that the “big beautiful bill” is kind of homely.  Bond markets around the world have been a bit shaky, particularly for long-duration paper, and the last thing they wanted was a piece of legislation that risks creating larger budget deficits in the world’s largest economy.   As I write this around noon EDT, however, bond traders have decided to buy the dip in their market, allowing stocks to edge higher.

Pre-market futures were a bit directionless early this morning but fell immediately after the news that the budget legislation had passed the House of Representatives.  The drawdown, though swift, abated after some comments from Federal Reserve Governor Waller that opened the door to potential rate cuts in the second half of the year.  I’m not sure that the door wasn’t already open for cuts later in the year – even the conservative comments from various Fed leadership that we discussed earlier this week acknowledged the possibility, if not the likelihood of one or two cuts – but Waller’s commentary was what traders wanted to hear at that moment.

All that said, we learned the hard way yesterday that the bond market has enough sway over equity pricing to disrupt even the most resolute traders.  A sloppy 20-year auction led to a rapid -1.6% selloff in the S&P 500 yesterday afternoon.

Quite frankly, I didn’t have yesterday’s 20-year auction on my meager list of potential catalysts for the week.  It’s not an auction that’s on most people’s radar.  It wasn’t on mine.  My concern for not shorting a dull tape proved to be quite misplaced just an hour after finishing yesterday’s piece.  In hindsight, the complacency that was pervading the market was in fact the reason for the unexpected shock. Complacent markets are often more easily stunned than wary ones.

After the initial dip in the bond market this morning, we see bond prices clawing back all of this morning’s and some of yesterday’s losses.  This is reminiscent of what we saw on Monday, when bonds initially sold off, then recovered.  Stocks followed bonds, with equity traders seemingly deciding that if bond traders weren’t perturbed by a debt downgrade, why should they?

Today’s gyrations aside, global bond markets should be giving pause to equity investors.  We’ve seen long rates creep higher in the US, Germany, Japan and elsewhere.   A concerted lack of fiscal discipline, along with the potential for global price pressures, have made bond investors more cautious.  This caution has not yet spread into global equities in a meaningful way, but it certainly would if the rate increases persist.  Remember, a stock’s current price is supposed to reflect the present value of its future earnings and/or cash flows.  The higher the interest rate, the lower the present value of those flows.  And if we think that highflying tech stocks would be immune from such concerns, stocks with higher P/E multiples can in fact be more susceptible to higher rates.

All this bears close scrutiny.  But for now, US traders once again seem more concerned about their plans for the long weekend and the unofficial start of summer than yields on global long-duration bonds.