Financial Markets Wall Street

The author says that, sometimes, when the conditions are ripe, even the tiniest spark can cause a conflagration within a speculative stock market. 

In the grand scheme of things, a small, upward blip in the yield of the U.S. 10-year Treasury bond should be of little concern to equity investors. But, sometimes, when the conditions are ripe, even the tiniest spark can cause a conflagration within a speculative stock market.

As readers are aware, interest rates have been trading at historically low levels for some time. The onset of the coronavirus forced our Federal Reserve Bank to pin them even lower.

Essentially, it is why the stock market has been having such a great run. Investors have been conditioned to just assume that, if anything, interest rates might trend even lower, but not higher. However, during the last few weeks, the yield on the benchmark 10-year U.S. Treasury bond has been moving higher. Since the beginning of the year, it has gained roughly one-half percent. But, real interest rates (minus the inflation rate) are still yielding nothing.

In just about every economic recovery, one should expect to see longer-term rates begin to rise somewhat. Economists have been arguing that a moderate rise in this benchmark bond’s yield should be good news for the stock market. That may be true, but skittish investors — accustomed to low rates, for longer, and imbued with so much speculative fever — are finding it difficult to accept that concept.

Investors are concerned that all the stimulus that the government has poured into the economy, plus all the trillions of dollars that the Biden administration is planning in the near future, will spark inflation. That, in turn, could force the Federal Reserve to raise interest rates and tighten monetary policy prematurely.

It doesn’t matter that just this week, Federal Reserve Bank Chairman Jerome Powell, in testifying before Congress, once again reiterated that the central bank has no intention of doing that. In fact, he said just the opposite. That calmed down investors for about a day, but it didn’t last.

Suddenly, the yield shot up to above 1.50 percent on the benchmark bond, and bond traders panicked. It was as if some magic level of interest rates was unearthed that would suddenly put an end to the entire economic recovery. The bears appear to be betting we are at the doorstep of that level.

It is the main reason why technology shares, especially the large-cap favorites, have been taking it on the chin all week.

Higher rates are considered the Achilles heel for that group. It is why the Nasdaq has suffered far greater declines than the S&P 500 Index this week. But, these large-cap companies are now also in so many equity indexes that investors cannot escape them. If stocks like Apple and Google decline, they will (and are) take the whole market down with them.

This week, we have seen the increasing volatility I have been expecting throughout the stock market. We have also seen another uptick in speculation, both to the upside and to the downside. Bitcoin has had some enormous swings, while gold has dropped to six-month lows. The U.S. dollar was first in a free fall and then soared higher. On top of all this, the Reddit/GameStop crew has returned with a vengeance.

For weeks, I have been advising readers to raise cash gradually while the markets climbed to new high after new high. If you had followed my advice, you should have a nice pile of cash available at this point in the event that markets take a real tumble. That time could be almost upon us.

As I write this, the markets are battling with an important technical level. A sustained move below 3,830 to 3,840 on the S&P 500 Index would signal to me that a correction is already unfolding. If so, my potential target would be around 3,550.

It hasn’t happened yet, but it could. In any event, whether it happens now or sometime in March, that correction is coming. Stay tuned.

Bill Schmick is registered as an investment adviser representative of Onota Partners Inc. in the Berkshires. He can be reached at 413-347-2401, or email him at billiams1948@gmail.com.