Are Interest Rates About to Spike Again?

NEW YORK (TheStreet) -- We may be at another crossroads here in the U.S. Treasury market.

At the start of the year, long-term Treasury bonds were oversold and sentiment was extremely negative after a horrible year for bonds in 2013. This set the stage for a sharp relief rally in bonds that pushed 10-year Treasury yields down from just over 3% to under 2.6%. The move lower in yields was accompanied by a short-lived, deflationary pulse which resulted in a 6% decline in the S&P 500 from mid-January through early February.

From the low in early February, the U.S. equity markets came roaring back, erasing all of the January decline and closing the month at new all-time highs. The one thing that was noticeably absent from the rally was a commensurate rise in bond yields. Not only did long-term bond yields not rise during the February advance, they actually moved marginally lower (see chart below). The move higher in stocks was not being supported by higher growth expectations via higher bond yields.

With U.S. equities sitting at all-time highs, the divergence is becoming stark. If the equity market bulls are correct in saying the recent downturn in economic data is entirely weather-related and transitory, bond yields should start to move substantially higher from here. Supporting this view is the particularly strong action in cyclical stocks, which tends to be bullish for equities overall and supportive of rising yields.

In the top panel of the chart below, you'll notice that the Morgan Stanley Cyclicals Index is hitting new multi-year highs relative to the S&P 500. At the same time, in the bottom panel you can see that 10-year Treasury yields have not been following cyclicals higher over the past few weeks. This divergent behavior is unlikely to persist.


If cyclicals are correct, we should start to see the tide of weaker-than-expected economic data turn. The next major test will be this Friday with the report of non-farm payrolls. The current expectation is for 150,000 new jobs, which would be a significant improvement from the December (75,000) and January (113,000) numbers.

If we see a sizable beat to these expectations, I would expect long duration bonds such as the iShares Barclays 20+ year Treasury ETF (TLT) to get crushed, with yields spiking higher. Currently, I view this as the more likely scenario as many of the important intermarket relationships I track are pointing to a continued risk-on environment.

However, if the report comes in below expectations, it will be difficult to continue to use weather as an excuse as expectations should have been lowered by now to account for colder weather. In this case, market participants may begin to wonder if bonds were right all along, and cyclicals could decline to resync down with bond yields.

It should be an interesting Friday morning, particularly in the bond market.


This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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