Stock investors, don't ignore bond market warnings

U.S. equities remain buoyant and strangely confident in the wake of the surprise Brexit vote two weeks ago. That's despite lingering evidence in the bond market that all is hardly well. Just look at Wall Street's action on Wednesday, as shares recovered from early-session weakness even with Europe's banking system continuing to be squeezed.

Italian banks are in focus amid political bickering over a possible bailout. The tailspin is catching the entire European banking industry, with Deutsche Bank (DB) collapsing well below its 2008-2009 financial crisis lows. In response to weakness in the pound sterling, more than five U.K. property funds have now suspended trading and blocked redemptions as investors scramble to sell in anticipation of further currency-driven losses.

The fear is reflected in the 10-year U.S. Treasury yield's collapse to a record low of 1.3 percent -- undercutting the prior trough set in July 2012 (chart below). Either stocks are right, and the situation will blow over as it did after the fiscal cliff fears, the taper tantrum, the 2014 Ebola scare and so many other scary events during this bull market -- or bonds are onto something serious.

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To summarize, catalysts for the malaise in fixed income include fears over the economic fallout from Brexit, political risk that the likes of Spain and Portugal could look to exit as well and the realization that any new monetary policy stimulus effort is likely to further reduce long-term interest rates and thus further pinch bank sector profitability.

Moreover, the drop in U.S. yields is in sympathy with an even deeper collapse in global government bond yields, with upwards of $10 trillion in sovereign debt now trading with negative interest rates. Countries with rates below zero include Germany, Japan, Switzerland and the eurozone as a whole.

Moving forward, watch for the weakness in European banks -- which U.S. financials ignored on Wednesday -- to deepen. The U.K. property fund freeze could also have a chilling effect if spurned investors sell other assets in an attempt to reduce their exposure to a weakening pound.

Also keep an eye on the ongoing surge in precious metals prices, which along with plunging long-term interest rates, indicates continuing nervousness in the global financial system since the Brexit vote that equity prices aren't yet reflecting (at least, not U.S. equity prices).

As for equity market sentiment, the latest Investors Intelligence polls are flashing 47 percent bulls to less than 25 percent bears. Confidence in equities -- reflecting the belief that the central banks can and will squash any sell-off attempt -- remains in fever territory. We're about to see whether or not that confidence is justified.

According to Goldman Sachs economists, the outcome will depend on whether the Federal Reserve does, in fact, raise interest rates this year. Current market odds put those chances at just 10 percent vs. the Fed's own estimate of 70 percent. If the Fed does hike rates again, it would badly destabilize stocks. Much depends on the course of inflation -- driven by crude oil, housing, job gains and possible wage hikes -- in the months to come.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.