The S&P 500 (NYSE: SPY) briefly hit bear market territory recently, following in the footsteps of the Nasdaq (NASDAQ: QQQ) and Russell 2000 (NYSE: IWM), before putting together a bounce out of oversold conditions. It's been an intense journey for the stock market with many major averages making new, all-time highs in the first week of January.
However, the bond market has been on an equally meaningful journey. For most of the past year, it's traded in tandem with stocks. This is due to inflation which makes bonds less unattractive and a hawkish Fed.
Now, there are signs that there could be more divergence between stocks and bonds which is a positive development for investors and market stability.
First, let's recap how we got here: 2022 started with hopes of another bullish year, following strong gains in 2020 and 2021. These hopes were quickly dashed as the stock and bond markets dropped around 10% primarily due to inflation and the growing consensus that aggressive hiking was imminent to curb the threat. Then, both markets bottomed and then chopped around these lower levels. In hindsight, it's actually quite impressive that markets were able to stay so resilient despite all the bearish developments.
In mid-April, both assets began another leg lower. However, at some point, the market's concerns shifted from inflation to growth. Some signs were weakness in cyclical stocks instead of high-multiple ones, rates moving lower, and signs that inflation is peaking.
Over the last couple of weeks, bonds have started to bounce, while stocks made new lows. The most likely interpretation is that bonds have priced in 'peak hawkishness' of the Fed ending the year with rates around 2.5%.
The 10-year Treasury yield increased from 1.6% at the start of the year and hit a peak of 3.12% on May 9th. Since then, yields have backed off to 2.86%. Any economic data showing that inflation is cooling or that growth is slowing would add to bond strength, while higher inflation would undercut it.
For stocks, the situation is much trickier as they would benefit from lower inflation but would be hurt by slowing growth. However, it does remove one market risk - the rise in rates was leading to liquidations in growth stocks which had the potential to trigger a domino effect in unrelated parts of the market. Bonds catching a bid removes this risk and could even lead to a bear market rally in growth stocks while cyclical stocks underperform.