INTEREST RATES FELL WITH STOCKS IN 1998 AND 1987, BUT THEN BOTTOMED WITH THEM AS WELL -- THE INABILITY OF BOND YIELDS TO BOUNCE IN 2000 LED TO MUCH BIGGER STOCK LOSSES -- RIGHT NOW, BOND YIELDS AREN'T BOUNCING WITH STOCKS

POSSIBLE LINK BETWEEN RATES AND STOCKS ... When volatility rises, asset classes become highly correlated. That's especially true with bonds and stocks. I'm referring here to bond "yields" instead of prices. Chart 1 shows that the 10-year T-Note yield (green line) and the S&P 500 (price bars line) have been trending in tandem since the start of the year. [That means that bond "prices" have trended in the "opposite" direction of the stock market]. Over the past week, stock prices have rebounded while bond yields haven't. I got to thinking about whether stocks needed a similar rebound in rates to support a market upturn. Let's take a look at what happened in 1998 and 1987.

Chart 1

INTEREST RATE AND STOCK LINK IN 1998 AND 1987... This analysis is admittedly an oversimplification of complicated market events. But it does show us a few things. Chart 2 compares the S&P 500 (price bars) and the 10-Year T-Note Yield (green line) during the market panic of 1998. There are two points worth noting. Both lines fell together from July to October as the market lost a little more than 20%. Of even more relevance is the fact that bond yields and stocks bottomed together in October 1998. Chart 3 shows the same 1998 linkage between the stock market and and 3-month T-Bill rate (red line). The same thing happened in 1987. The red line in Chart 4 is the 3-month Treasury bill rate compared to the S&P 500 during 1987. There again, rates fell along with stocks from the August peak to the October bottom. And again, T-bill rates bottomed along with stocks. Although it's only two examples, it does suggest at least two things. One is that it's common for interest rates (short and long) to fall with stocks (as investors flee to the safety of T-Bills and T-Bonds). Once the crises passed, however, rates rose along with stocks (as investors moved back into the riskier stock market).

Chart 2

Chart 3

Chart 4

BUT WHAT ABOUT 2000?... Admittedly, 1998 and 1987 represented relatively short-term market panics. Both only lasted about three months after which the stock market turned back up again. In both cases, however, short and long-term rates turned up with stocks. What happens when interest rates don't turn up? The year 2000 is an example of that. Chart 5 compares the S&P 500 (price bars) to the yield on the 10-year T-Note (green line). During that summer, both started falling together (as investors started selling stocks and buying bonds). Stocks attempted an August rally. Bond yields, however, stayed down and continued to drop well beyond October. The end result was that the stock market followed yields lower until both bottomed together in 2003. That positive linkage isn't unusual. Chart 6 shows a generally positive correlation between the 10-Year T-bond Yield (green line) and the S&P 500 over the last nine years (in other words, they usually rose and fell together). Both bottomed together in the fall of 1998, peaked together in 2000, and turned up together in 2003. All of which would seem to suggest that the stock market may indeed need for rates to turn up from here to support a serious stock rally. The reason is that the direction of rates tells us something about the economy. Rates rise when the economy is strong, and fall when it's weak. The same is true for stocks.

Chart 5

Chart 6

SHORT-TERM RATES BOUNCE, BUT BONDS DON'T... Chart 7 shows the direction of the 10-Year T-Note Yield over the last year. It also shows the steep slide since mid-June from 5.3% to 4.6%. The TNX is testing a trendline drawn below the December/March lows, and remains below its 200-day moving average. If the previous analysis is correct, the inability of bond yields to bounce over the last week may limit the market's upside potential. Chart 8 shows the dramatic plunge in the 3-month T-Bill rate over the last week (the biggest plunge since 1987). The yield has bounced from below 3% to just over 3.5%. There again, more convincing evidence that short-term rates have bottomed may also be needed to support a stock market rally. That's because a bottom in short-term rates might indicate that the panic flight to the safety of T-Bills has run its course. A bounce in bond yields would suggest that investors are confident enough to start moving out of bonds and back into the riskier stock market. In the previous panics of 1998 and 1987, T-Bond and T-Bill rates rose along with stocks after those two crises passed.

Chart 7

Chart 8