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Record lows in US bonds are signalling a reckoning with stocks

Despite a post-Brexit risk-on rally in stocks, the market for US government bonds is telling a conflicting story. The yields on 30 and 10-year debt plunged to historic lows Tuesday, reaching 2.13% and 1.34%, respectively.

Capital flows around the world are searching for both safety and returns—and the US happens to be the destination of choice for both. This is not the historical norm, but also not an unprecedented aberration.

According to Reuters, “low-risk money market funds attracted $25.1 billion in new cash in the week ended [Wednesday,] June 29…In addition, stock funds posted $6.8 billion in outflows to mark their biggest withdrawals since early May, while taxable bond funds posted $2.6 billion in outflows after raking in $2.5 billion the prior week.”

History rhymes

There are two distinct scenarios when stocks and US bond yields become highly correlated. The first is when they are both trending down. It’s an indication of pure risk aversion—there are haven flows into safe government bonds along with a flight out of stocks. The second is when they’re both trending upwards. That’s the present case—when the US is both a safe haven and a source of yield.

Source: Yahoo Finance, Tradestation

The last time we were in this situation was when Russia defaulted on its debt in 1998. Prior to that, there was the stock market boom of the mid-1980s, which culminated in a spectacular bust in October, 1987. Prior to the collapse, haven flows again favored the US and Japan, as emerging markets were under pressure.

Referencing these two precedents, it’s likely that the stock market will rally to new highs. But global risk aversion will eventually win out, culminating in a finale to this seven year secular bull market.

Credit leads equities. And in that regard, a final reckoning awaits investors, as the bond market makes the case for risk aversion. According to Yves Lamoureux, President of Lamoureux & Co., we are at the beginning of the third wave of a larger credit cycle—the final wave being much more volatile than the prior two.

Says, Lamoureux, “Much like 2007, credit risk moves in waves. Like 2007, we have felt the brunt of two consecutives waves. What really matters is the third one and where most people will hold on to their dear life.”