Bond Market Slump Could Presage a Big Stock Market Selloff - TheStreet

That giant hissing sound you hear is indeed a financial market bubble deflating. For months, countless headlines in the financial press have detailed the impending stock market decline. Headlines like "Dow 19,000 is no cause for celebration" and "Stocks at all-time highs calls for extreme caution" are commonplace. It is only a matter of time, it seems, before the inevitable correction or crash in the stock market occurs.

The smart money was certainly on a sharp decline in the stock market upon the unlikely election of Donald Trump as president. But that stock market correction lasted only a couple of hours. Stock futures plunged on election night when it became clear Trump was going to win, only to sharply reverse course when the President-elect struck an unexpected conciliatory chord in the wee hours of the next morning.

The current bursting of the financial bubble is not playing out in the stock market, but in the usually more staid bond market. Many market participants have not noticed this upheaval, because focusing on the stock market is apparently much more interesting, and because many investors wrongly believe that stocks are risky and bonds are safe.

What many don't understand is that the government bond market is largely about mathematics. Simply put, when interest rates in the market rise, prices of existing bonds fall. Interest rates are rising as a result of many factors including promised increases in infrastructure spending by the Trump administration and the likelihood the Federal Reserve will increase its benchmark federal funds rate next month.

But that isn't the entire story. When market interest rates rise from very low levels, the drop in bond prices is much more acute. That is, a rise from 1.5% to 2% causes a much larger fall in bond prices than a rise from 5% to 5.5%. With bond yields coming off historically low levels, it was only a matter of time until rates rose.

The last few days have seen a bloodbath in the bond markets. As Allan Sloan detailed in The Washington Post, an investor in a 10-year U.S. government note would have lost nearly 5% of value in a scant eight trading days. Most investors believe those kinds of losses are reserved for risk-takers in the equity markets, not to those investing in supposedly "safe" government bonds.

Equity investors shouldn't feel too smug or secure. As bond yields rise, the return promised to bondholders will begin to look more appealing than the likely returns in a stock market bid up to lofty levels (as measured by fundamentals such as price-to-earnings ratios and expected earnings growth). At that point we will see a rotation from stocks to bonds, putting pressure on stock valuations.

This article is commentary by an independent contributor. Robert R. Johnson is president and CEO of the American College of Financial Services.