What's Next for Stocks? Check Out the Bond Market

Breaking down warning signs on stock charts related to bonds and junk bonds

CFA, Senior Market Strategist
Mar 2, 2021 at 4:37 PM
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The recent spike in bond yields drove many investors to the sidelines last week, as higher yields drive down the value of future cash flows.  As a result, the most impacted companies during last week’s selloff were growth names with big projected future profits. The selloff was broad-based in technology names, as the Nasdaq Composite (IXIC) shed 5% of its value between February 19 and  February 26. 

Yesterday’s strong bounce in stocks came on the heels of a relief rally in bonds (as yields dropped significantly), and oversold conditions in many tech bellwether names like Apple (APPL). Whether this is a one-off event or the beginning of a new trend remains to be seen, but there are a few key indicators to watch that could potentially signal the next move for stocks.

The long end of the bond curve (10-30 year duration) is a proxy for inflation. As long-term yields increase, so do future inflation expectations. The 30-year bond yield has rallied sharply this year, but may have finally reached an area where market forces could drive it lower. The 2.4% area has been critical, as it served as a key inflection point for rates in late 2019. This level once again capped the rate spike last week, and should be at the forefront of traders’ minds moving forward.  A significant move through the 2.4-2.5% area on the 30-year yield would be a clear risk-off sign for stocks.  For now,  however, investors have embraced the recent decline in yields and stocks rallied sharply to begin the week.

TYX reflection of bond market

Another proxy for risk appetite is the junk bond market.  There’s a strong correlation between junk bond prices and stocks. These riskier debt instruments show investor confidence in companies that may not be as financially sound as most. SPDR Bloomberg Barclays High Yield Bond ETF (NYSEARCA:JNK) is the junk bond ETF and it has been in a strong uptrend since the market bottomed last March.  Although this uptrend remains, it’s starting to show some cracks in the momentum.  Looking at the chart below, you’ll notice some negative divergences in both the Relative Strength Index (RSI) and moving average convergence divergence (MACD.) These divergences are a warning sign, but not necessarily a “sell stocks” signal.  Moving forward, keep a close eye on the 107.50 area. This served as key support for JNK earlier this year, and a move below there could be a sign that the rally in junk bonds (and coincidently, stocks) might be over.

JNK reflection of bond market

Last week’s dip looks to be a buying opportunity at this point, but keep a close eye on these canaries for a sign of the next potential big move in stocks.

 

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