With the April
coming out Friday morning, these are dangerous times for the bond market. Which is to say these are dangerous times for stocks.
Since last week's first-quarter
gross domestic product
report came in, showing surprising strength in the economy, the yield on the 30-year long bond has climbed to 5.78% -- above its three-month range of about 5.5% to 5.7%. A strong jobs report could force yields decisively above that range, to the detriment of the stock market.
For some time, bonds have been the wind at Wall Street's back. Though yields are well off the lows they hit back in October, when the global economy looked to be on the brink, they are still at low levels when measured by history's yardstick. Benign interest rates help stocks in two ways. First, they make companies' cost of capital low, allowing them to grow more quickly. Second, they make the return on stocks more attractive than the lower yield on fixed-income.
Even though the yield on the long bond has been relatively low, many strategists who use asset allocation models that judge how expensive stocks are relative to bonds --
Morgan Stanley Dean Witter's
Byron Wien and
Doug Cliggott are a couple -- say that stocks are expensive. "This thing is stretched," says Cliggott of his model, which shows the
overvalued by 32%. A fall-off in the Treasuries could make stocks, at least the big-cap growth issues that dominate the S&P, look still more dear.
With the 30-year Treasury threatening to break its range, it's important to recognize that what's been moving the bonds lower lately is really the same thing that caused all the recent rotation and broadening out in the equity market: a perception that the global economy is getting back on its feet.
When investors were nervous about the world, they fled to the safety of the Treasury market and stocks in a select group of U.S. companies that were seen as able to grow no matter what. With the recognition that things are getting better in the world, money started to exit both bonds and growth stocks and seek out the areas that were beaten down hardest by the economic turmoil, and now stood to make good gains. So we've seen money going into emerging markets and value, cyclical and small-cap stocks.
With the world getting better, there's increased fear that the
will need to raise rates. This is not so much because an improving world economy will fuel inflation -- the world may be getting back on its feet, but it isn't growing like mad -- but because the Fed can raise rates without worrying so much that doing so would send the world economy into a tizzy. And with
gross domestic product
growing like gangbusters, and unemployment at its lowest levels in over 30 years, the Fed's got reason to worry that inflation, long dormant, could be roused anew.
"There are clear signs that the world is not falling apart, and there's clear evidence that the domestic economy continues to barrel along," says Peter Canelo, U.S. investment strategist at Morgan Stanley Dean Witter. "The bond market cannot be so passive about strong statistics."
A jobs number strong enough to make the bonds break their range and move lower (pushing yields up) would doubtless hurt the stock market, but it would not hurt all stocks equally. While such a development would be bad for growth stocks, rising yields need not hurt stocks whose prospects rise and fall with the economy so long as the improvement in their earnings outstrips the rise in rates.
Yet it is important not to equate the market's actions with an imminent recovery in the world economy, Cliggott points out. "To be able to stand up with confidence and say, 'Health has been restored to the global economy' -- I don't think you can make that statement in 1999," he says. And Cliggott is just as careful to note that what we've seen happen to stocks and bonds doesn't portend imminent rate hikes, either. "Value stocks started outperforming growth stocks in early 1992," he points out. "It wasn't a one-way street, but you didn't have interest rates moving until early 1994. The market plays things out far more quickly than economics do."