Why Traders Must Watch the Yield Curve

The action in the CBOE 10-Year Treasury Note Yield Index (TNX - 21.57) -- which tracks current bond yields at a multiple of 10 -- has been somewhat unexpected in 2017. Stocks and bond yields have traditionally moved in the same direction, with both maintaining an inverse relationship with bond prices. However, while TNX has dropped about 18% from its mid-March high of 26.15, the S&P 500 Index (SPX) has gained 2% in the same time frame.

In fact, while the S&P 500 and its fellow equity indexes are treading around record highs, TNX has backpedaled to seven-month lows -- and more specifically, into territory the bond yield index hasn't visited since Nov. 9, in the immediate aftermath of the U.S. presidential election. TNX popped that day, rallying alongside stocks as the two maintained their "traditional" correlation, and peaked at 20.90 intraday (equivalent to a 2.09% yield).

The sharp post-election advance in TNX carried the index as high as 26.21 by Dec. 15 -- a peak that was closely mirrored by the March high mentioned earlier. The "neckline" of the resulting double top formation was broken in early April, shortly after TNX broke below former support at its 80-day moving average. Since then, TNX has gone on to break support at its 160-day and 200-day moving averages, as well -- with both trendlines appearing to switch roles almost immediately to thwart ensuing rebound attempts by TNX.

And while the double top in TNX correctly predicted the continued downside in the index over the next couple of months, it's worth revisiting this chart in the here and now, after TNX's Wednesday low at 21.03 effectively filled the post-election bull gap. With bonds looking pretty overbought -- the rallying TLT sports a Relative Strength Index (RSI) of 66, and on Wednesday (coincident with that TNX low) closed above its upper Bollinger Band -- yields could easily spike higher from here, with the TNX 21 level (a 2.10% yield) providing support.

Conventional wisdom states that a continued breakdown in yields would be negative for stocks, but it certainly hasn't mattered to this point in the year. With stocks and yields reevaluating their relationship status, so to speak, we'd suggest that the steepness of the yield curve is likely more critical than the actual level of yields. The Fed generally has more effect on the front end of the curve (i.e., 2-year yields), and the 30-year yield is typically viewed as a barometer for economic growth. Should the curve flatten, that would be a very negative development for stocks -- and particularly within the finance sector.