Interest rates

For those of you not paying attention, the bond market has had an amazing month and a half!

If you are thinking to yourself, “What does the bond market have to do with anything, I buy stocks,” hold on to your hat.

Bonds are frequently used as the discount rate or the base rate from which discount rates on stocks are computed. This is most prevalently seen in the Fed Model, but is also the way almost every finance textbook used in business school starts.

If bonds drop in price, and their yields go up (as has happened lately), then stock prices should go down (all things being equal, and they never are). By how much? I’ll get to that below.

Back on May 2nd, the 10 year yield on US Treasury bonds was 4.64% and the 3 month yield on US Treasury bills was 4.87% (according to Value Line’s May 11 Selection and Opinion). Today, according to PIMCO’s website, the 10 year is yielding 5.30% and the 3 month is yielding 4.72%.

This is a massive change! The 10 year’s yield jumped 0.66% and the 3 month’s yield dove 0.15%. Because the bond market has such a huge impact on all discount rates in the market, this is a huge change!

For those of you thinking the stock market’s recent sell off has taken account of such a discount rate change, think again. The DJIA was at $13,211.88 on May 2nd and closed at $13,295.01 today, a 0.63% increase. All things being equal (assuming estimates on company earnings haven’t changed), the DJIA should be at $11,566.60–down 12.45%! Instead, it’s at $13,295.01, implying that earnings estimates for the DJIA have increased by 14.95% in the past month? I doubt that.

I’m NOT suggesting the Fed Model is correct or that stock prices should move precisely with bond yields, but I am suggesting that the stock market, and perhaps other markets, have not taken full account of recent bond price and yield movements.

Also, how do you think bond price moves will impact mortgage and housing markets? A 30 year mortgage on a $300,000 house should go up around 7% per month (or $130) based on this bond price change. Does it seem like that’s been figured into market prices for home builders and mortgage companies? It doesn’t seem like it to me.

As usual, I’m making no assumptions about what will happen in the market and when, but I do find recent bond market moves disturbing.

Perhaps bond prices and yields will go back to where they were, vindicating recent stock market moves. Perhaps fundamentals are improving just as quickly as bond prices are dropping and this justifies no move in prices.

I can’t predict what will happen much better than the next guy, but I am scratching my head and wondering what other people in the market are thinking.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.