It's Not The Size That Matters, It's The Speed (Of The Selloff)

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Earlier this week we looked at the key threshold  in the 10Y TSY, beyond which stocks would be slammed, with most banks agreeing that anything above 2.70% and it’s “watch out below” for stocks. The subsequent 2-day selloff, the biggest since September 2016, appeared to confirm this skepticism.

But what if it’s not the size, but rather the speed of the selloff that matters?

That is the argument behind a bond market signal for equity investors, which shows the deterioration in credit may already be happening too fast for equities to withstand. The indicator – first noted by Bloomberg – is the Leuthold Group’s Dow Bond Oscillator, and it just flashed a reading that has spelled trouble for equities before, and may have bitten Tuesday as the S&P 500 slid the most since August.

While the recent selloff is certainly troubling, with the 10Y yield moments ago sliding to the highest level since April 2014 at 2.7387%.. .

… to Doug Ramsey, chief investment officer at Leuthold, the market has been caught off guard not by how high yields are as bond prices weaken, but how fast they’re going up.

“Everyone is focused on a rate level, but the rate-of-change is impacting things at almost a subconscious level,” Ramsey said. “The upward trend in rates is already sufficient to slow or reverse the market’s ascent.”

As Bloomberg further explains, “basically the model looks at how quickly returns are weakening in corporate credit. Namely, it’s the 10-week exponential moving average of the 26-week percentage change in the Dow Jones Corporate Bond Index (which measures price, the reciprocal of yields). The lower it goes, the tighter monetary conditions, and therefore worse for stocks.”

So far the indicator has been spot on: Leuthold’s gauge dipped below zero last week for the first time since June, triggering a sell signal for shareholders. It’s one reason the firm cut equity holdings in its core and global funds to 58 percent from 65 percent.

Of course, in a world where risk-parity funds have become the dominant price setters, and where getting the bond-equity relationship right is key for stock investors, whether Leuthold is right could mean the difference between a profitable year and a rout, especially if the Fed continues to hike rates. And, while some have warned of trouble for stocks if 10-year Treasury yields rise above 3 percent – according to Bloomberg – or 2.7% according to us, an alternate view of Ramsey’s theory is that market might be fine should the ascent in rates slow.

The problem is that with everyone on one side of the market, or the other, such phase shifts are never slow, and certainly not without turbulence. In other words, once the squeeze begins, it will only accelerate, triggering both the size and speed indicators.

Leuthold studied market performance since 1920 and found that the Dow Bond Oscillator has shown a good track record of predicting equity returns. When it stayed below zero, as in the case now, the Dow Jones Industrial Average fell at an average annualized rate of 0.3 percent. Equity returns were more robust, rising 11 percent, when readings were above zero.

“It’s the rate-of-change in bonds, not the bond yield level, that has the stronger impact on the stock market,” Ramsey said.

If the selloff in the 10Y accelerates, and the S&P turns red as it appears to be getting ready to do, Leuthold will likely be right.