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Rising bond yields could win next round in battle with stock market

  • Bonds and stocks are in a heated battle, as bond yields rise and stocks sell off.
  • The bond market could win the next round, but a weaker stock market can also cause a drop in yields, which move opposite price.
  • Thursday's markets are watching for more clarity on Washington's budget deal and a $16 billion 30-year bond auction.
Traders work on the floor of the New York Stock Exchange (NYSE).
Getty Images
Traders work on the floor of the New York Stock Exchange (NYSE).

The bond market is ready to turn up the heat even more on the stock market.

Stocks closed lower Wednesday, but not before swinging wildly to sharply higher and lower levels, as interest rates rose.

Treasury yields moved higher on the day. The latest tantrum came on concerns about more deficit spending in Washington, after the Senate struck a budget deal that raises the spending cap by $300 billion, more than the market expected. A soft 10-year auction added to the jump in yields, which move opposite prices.

The S&P 500 Wednesday closed down a half percent at 2,681, after rising as much as 1.2 percent. The move was its biggest one-day reversal since February 2016.

Congressional efforts to approve a budget deal and avoid a government shutdown should remain in the headlines Thursday and could continue to stir discontent in the bond market.

For Thursday, traders are also watching the Treasury's auction of $16 billion in 30-year bonds, concerned it too could send yields higher. Jobless claims are released Thursday morning at 8:30 a.m. ET, but there's no major data until CPI and retail sales data next Wednesday.

"I would expect probably not a terrific day [Thursday]. It's been pretty ugly. A lot of people are groping around trying to find the cause of the equity sell-off and most people are pointing to expectations for higher bond yields," said Michael Schumacher, director of rate strategy at Wells Fargo. The 10-year was at 2.84 percent Wednesday afternoon, after edging to 2.86 percent, just under its high for the week of 2.88 percent.

"If 2.88 scared people why would they be comfortable with 2.84/2.85," said Schumacher.

Low interest rates have made risk assets more attractive for years, and a change in that environment is creating a shakeout in stock valuations. But once stocks react too much to rising interest rates, traders expect a flight to safety back to bonds, which would drive yields lower.

"You could get into a little bit of circular logic here, as you hand leadership back and forth. Today it feels like leadership is going back to the rate market and now stocks are reacting to it," said John Briggs, head of strategy at NatWest Markets.

The close correlation between stock market weakness and the bond market's efforts to push yields to a higher range is expected to continue to cause volatility in both markets. Some stock strategists say the stock market may have found a near term bottom Wednesday but the volatility is expected to continue.

"I think there's going to be an interplay between equities and rates probably for the next several months, until we get greater clarity on how the overall growth outlook is going to be and if the Fed is thinking about shifting the reaction function," said Mark Cabana, head of U.S. short rates at Bank of America Merrill Lynch.

The bond market has been reacting to the idea that Fed interest rate hikes could come more rapidly than expected, particularly if inflation starts to rise. At the same time, the U.S. deficit is growing and would be bumped up even more by the Senate budget deal, if it passes Congress.

"It's just the latest log on the fire," said Schumacher. Even before the budget deal, the Treasury is ramping up new debt issuance to pay for tax cuts and entitlements. Schumacher said the Treasury is expected to have net issuance of more than $600 billion in notes and bonds for the 2018 calendar year, and about $1 trillion if Treasury bills are included. That compares with $420 billion net last year in notes and bonds.

The market is nervous about new supply coming to the market this year as the Fed not only raises rates but continues its program to buy fewer and fewer Treasury securities, in the unwind of extraordinary easing instituted in the financial crisis. To vex bond traders even more, there are signs other central banks will pull away from the easing that has helped keep interest rates low for years, and made U.S. Treasurys more attractive than rivals in other countries where interest rates went negative.

"We're in this interest rate bed all together. If someone has a bad night's sleep, it's going to affect other people. The ECB [European Central Bank] cut their quantitative easing in half. I can guarantee European bonds are not going to be sitting where they are now as the ECB gets near the end of their tightening," said Peter Boockvar, chief investment strategist at Bleakley Financial Group.

Boockvar said the U.S. bond market is responding to rising German bund yields, which are expected to keep rising.

"The interest rates and volatility beach ball was suppressed under water, sat on by the 1,000-pound gorilla of the Fed, the ECB, and the Bank of England. When that ball bounces out, it's going to spike," said Boockvar.

Fed speakers will get a lot of attention Thursday. Dallas Fed President Robert Kaplan speaks at 4:50 a.m. ET in Frankfurt, Germany.

Philadelphia Fed President Patrick Harker speaks at 8 a.m. ET in New York, and both Minneapolis Fed President Neel Kashkari and Kansas City Fed President Esther George have 9 a.m. appearances.

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