Low yields could mean trouble for stocks

The betting is stocks will ride higher into the new year, but the bond market is having a party of its own–and that could ultimately spell trouble.

While analysts see stocks continuing to creep to new highs, there could be a time when investors decide the signal the from the bond market is not especially positive. Jack Ablin, CIO of BMO Private Bank, says the day of reckoning could come in the first quarter, and he expects a new year sell off.

"The only two legs left for stocks are the economy and momentum. The economy looks pretty good and momentum looks good," he said. "My sense is that we're going to see the market rally into year-end as active managers try to catch up, and then in the first quarter, sell off."

Traders on the floor of the New York Stock Exchange.
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Traders on the floor of the New York Stock Exchange.

Friday closes the book on the month of November and buying was strong in the bond market ahead of that as investors squared positions. Some traders say yields could continue to go lower, and the 10-year–at about 2.24 percent Wednesday—could revisit its closing low yield of the year of 2.14 percent before December is over.

There is no data expected Friday, but bond traders and stock traders will be watching the early readings on Black Friday shopping and the reaction in the oil market after OPEC's Thursday meeting. The stock and bond markets are closed on Thanksgiving, and both have shortened trading days Friday.

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Ablin said he has become a little more cautious on stocks as credit spreads have climbed steadily since mid-summer. The spread between investment grade corporates and the 10-year Treasury has widened by about five basis points over its one-month range, but high yield debt is about 28 basis points wider than a month ago, according to Barclays. The spread between high yield and the 10-year Treasury was about 478 basis points.

"(Stocks) rallied back and credit spreads didn't narrow. That was really my concern," he said. "My sense is, maybe because of my bias as a former bond trader, I always believe the bond market more than the stock market."

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Lower yields in Europe and Japan have been sending buyers into Treasurys, pulling down U.S. yields. The German 10-year bund was at 0.68 percent Wednesday. The spread between the U.S. 10-year and bund has been hovering in a 14-year wide zone near 150.

Ward McCarthy, chief financial economist at Jefferies said some of the impact on high yield spreads has been the weakness in the energy sector, as oil prices declined. "There's been a divergence in the performance of the equity market relative to high yield and that's a little bit unnerving. It suggests that with either one market or other, there's going to be a convergence at some point. It's either stocks weaken—or does the high yield market get a bid again?" he said.

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As for the energy sector decline, "there's a flip side to that. The flips side is there are a lot of other sectors that should benefit from the weaker energy price."

Strategists say besides the relative attractiveness of U.S. Treasurys versus other sovereigns has been a catalyst for buying, but also the Fed is still a factor even after quantitative easing ended last month. The market is also reacting to worries about the global economy, and on Wednesday some disappointing U.S. data on housing, durable goods orders and consumer spending also encouraged buying.

"(Fed Chair Janet) Yellen has definitely made it her thing that she is very much in the dovish camp," said Arthur Bass, co-head of Financial Futures and Options in New York for Societe Generale/Newedge.

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Bass said one reason the market believes the Fed will not raise rates before next September is because it seems to change the rules on its own guidance. The Fed once had marked unemployment at 6.5 percent as a point where it would consider rate hikes, he noted.

"At this point, we're not far from 5.5 percent, 5.5 used to be viewed as full employment. We're at 5.8," he said.

"Marketwise I think people are tired of fighting the Fed," he said, noting that the number of shorts in in the market is the lowest since February.

"It just seems the goal posts are moving, and obviously the attention is now on inflation, which is important, and getting inflation up to 2 percent," Bass said.

McCarthy said the bond market will be paying close attention to OPEC this week because falling oil prices could mean even less inflation. The Fed has already said the drop in energy prices was a temporary factor impacting inflation.