During the onset of Covid-19, government bond yields cratered as the Federal Reserve took extraordinary measures to prop up the stock market. As a result, bond prices soared – but today, the exact opposite is happening and it’s bound to have an impact on stock returns.

Seeing the 10-year U.S. Treasury yield at 2.5% was unimaginable just a year ago, but here we are and the circumstances are quite different. A whole lot can change in 12 months, and the government’s money printing and spending in response to Covid-19 was bound to have consequences.

Those consequences are unavoidable now. From food to gas to housing, all of the most basic necessities in life cost more – a lot more. The 7.9% CPI print doesn’t even tell the full story of how expensive essential items have become in 2022.

The last time Jerome Powell’s Fed raised the 10-year Treasury yield to 3% was in Q3 of 2018, and that immediately led to a 20% stock market correction. After that, it didn’t take long for Powell to backpedal and dial down bond yields.

Today, it’s a different situation as the Fed is under enormous pressure to lower bond yields in order to contain rampant inflation. In anticipation of seven probably interest-rate hikes this year, possibly including some half-percentage-point raises, bond traders have pushed up yields and suppressed bond prices.

The result is the start of the third great bond bear market, according to Bank of America strategists. If you can believe it, U.S. bond prices are currently on track for their worst year since 1949.

Courtesy: MarketWatch

The prior bond-price bear markets took place from 1899 to 1920, and from 1946 to 1981. They were accompanied by major events, such as the enactment of the Marshall Plan.

An interesting consequence of the current bond-price rout is that the total value of the world’s negative-yielding bonds has quickly shrunk, from around $18 trillion to less than $2 trillion. On the other hand, real yields, which subtract the inflation rate from bond yields, are still negative across the board in the U.S.

Another upshot is that U.S. Treasurys are unusually illiquid, as the bond prices are collapsing and fewer traders want to get involved in these toxic assets. “It can be very painful to hold bonds and, in aggregate, it feels like we’re not seeing as many end users buy Treasurys bonds as we have before, with demand lower,” explained JPMorgan rates strategist Alex Roever.

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    When a market is relatively illiquid, prices can swing wildly and traders can get wiped out. For the foreseeable future, we can expect bond yields and prices to be particularly sensitive to any news developments concerning the Fed and inflation.

    The situation is so critical now that it’s actually setting off alarm bells in the bond market. As seen in JPMorgan’s Liquidity Stress Dashboard, 10 of the gauges being monitored were recently flashing either a “RED” or an “Amber” status:

    Courtesy: MarketWatch

    The lack of Treasury market depth could signal trouble for the bond market, which is especially prone to irregularities now. This would undoubtedly have ripple effects impacting other financial markets, including stocks.

    So far, the stock market has managed to shrug off this potential threat. Still, the specter of a multi-market shock looms as stock investors are the most vulnerable when they’re complacent.

    At the same time, the 2-year Treasury yield of 2.28% is getting ever closer to the 10-year Treasury yield of around 2.5%. If the 2-year yield surpasses the 10-year yield, then we have a classic yield inversion and that spells trouble.

    According to Principal Global Investors, the U.S. Treasury yield curve has inverted ahead of every U.S. recession since the 1950s. There’s no inversion currently, but it’s definitely something to keep an eye on.

    “The yield curve has the best track record within financial markets of predicting recessions,” explained Ben Emons, managing director of global macro strategy at Medley Global Advisors in New York.

    For the time being, though, stocks are fairly safe to hold. The crucial thing is to stay diversified – gold and silver are ideal for this purpose – and continue to monitor not only your favorite stocks, but also bond yields and, of course, the ever-important dollar.

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