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Bonds: Pay attention if trading equities



The regime change from the past



Since the early 2000s the case for the trading industry especially equities or crypto has been that the bonds are not very relevant to figuring out directional trend changes in risk-on assets on daily or weekly basis. Paying attention to bonds was not on priority list to defining trends or bottoms in equities. This was all not because the mechanics of market flows have changed since past 100 years but because of the situational conditions we were present in past decades of the deflationary environment with ever-decreasing interest rates, pushing the attention away from credit markets and towards riskier assets such as equities where most of action was.

And sure every few years there was a credit event that pulled some attention back to bonds again for the trading community, but that did not last long before the central banks introduced the holy grail solution of patching the holes in market by introducing a fresh QE stimulus package. Every. Single. Time. Like a clock work.

This meant the credit markets got attention for few months or perhaps a year at once (around the credit event) and then after that it was all back to status quo. Forget about credit, focus on just equities.


This can create complacency in recent times for those new to markets without much historical research because one might think that this is a new norm that will forever stay present, but history tells us one thing: Everything is cyclical.


This means low-interest eras only last so long before the cycle ends and inverses, with a sharp increase in regional or sometimes global interest rates rise. When that happens, the global markets and their hidden controlling hands of institutional capital start to pay very close attention to credit/bond markets once again. That era typically lasts for a decade or sometimes even more. This is where we are currently.

If large participants are paying attention to credit and triggering the flows from there outwards, so should you pay attention as retailer to be more timely on the trend changes, especially now that equities have become much more sensitive to credit market movements unlike in prior decades.


Equities and bond price correlation over past 12 months:





The basics of flows, bonds as the core of a liquidity pool


A simplified view would be, the credit markets are the core of the financial markets, and the increased or decreased risks present within credit itself determine whether global flows will turn towards equities or other risk assets or move away from them.


Typically when a new situation emerges that is problematic and the market has not yet priced it in, the bonds will react negatively with a selloff (and yields will spike) which will impact the risk-on assets such as equities as well and pull the flows away.

On the other hand, if the central bank was to flood the system with liquidity and QE that would decrease the risks in credit and therefore provide more "side" capital to increase flows into equities. That is very roughly simplifying the flows that one should understand.


When inflation rises, central banks have to raise interest rates to catch up to the inflation, this increases the yields on the debt issued but so does increase the frictions within the credit system because many over-leveraged players within the system can start feeling pain or even going bankrupt. This creates outflows from cheap and low-grade corporative credit into higher-grade credit (10y treasuries for example). As corporative credit weakens so do the equities because the underlying balance sheets of companies weaken over time because of it. Or the consumer's credit quality slumps creating the contraction on credit use, leading to lesser profits for the corporation, reduction of their earnings, and therefore the same reaction over time which is the slump in equity prices. Lower valuations. This is what typically happens in inflationary cycles.


This means typically each time something new happens in global markets that are risky and unexpected-negative, the credit reacts. One has to expect equities to sooner rather than later to catch up to those flows of credit as well and sell off along with it.

This is not typical in a deflationary environment because everyone understands the central bank is going to step in and fix the issue by providing the QE (2010-2020), but in an inflationary area of QT (2022+) (quantitative tightening) that is not necessarily the case. Central banks stop propping the markets directly, at least not until interest rate hikes end. This creates more fear in credit markets and institutions start to pull the plug as "FEDs put" is no longer in place to the same extent.

Because the risk events over the past 3 years have been ramping endlessly it goes without saying that one should be paying close attention to credit markets, therefore. This is not 2017 anymore. 1970s are calling and they want their gloomy glory back.



To help with the timing of equities on their potential tops and bottoms credit market flows are an important segment of that in the current era of higher inflation and risk-off mode constantly present. To time the cycle changes in equities in general, therefore, one should be paying attention to bonds, especially on the big picture since this isn't so much about day-to-day changes but week-to-week trend durations or reversals.


Millennial YOLO Trader asking: What is a bond and why should i care?



Because for so long time we were in the era of low-interest rates and deflation+globalization macro cycle (1990s-2020) some traders and market participants have completely forgotten about the role of bond markets. This can be quite noticeable just over the past 12 months, where in trading communities very small portion even pays attention to credit instrument movements, even if they trade large cap equities.

If you don't pay attention to credit, how do you explain to yourself the reasons why the equities moved the way they did over the past 12 months where a large portion of movements had credit risk repricing as the major mechanism behind it. As we are entering an inflationary period that historically lasts for entire decade, it highlights that now is the time for everyone that has anything to do with markets to start paying much closer attention to credit markets. Luckily it doesn't require too complicated a method to implement into trading on a daily basis, the article will outline how one should go about it quickly.


The basic equation goes like this:


-When a new risk-off event happens, if unexpected and not yet priced in=expect bonds to the selloff.


-As this happens=expect the equities and crypto to sell off as well (if bonds plunge decent % amount). Adjust your swing positions or intraday expectations accordingly, but understand that there is a timing delay often of a few days. More about that under.


The key to highlight: There has to be sustained weakening of bond prices that lasts for days typically to drag the equities along with it. Therefore not just any small moves in bonds should be implemented as part of trading calibration of equities, but more significant reactions or reactions where trend in bonds sets clearly with firm volatility.



The time delay in reaction is useful divergence signal


Although I do not know if this is typical historically, so far over the past year we have seen that credit reacts often first, and then there are several days of delay and equities react after that. Markets have to chew on the change and turn the tanker slowly around, and that counts for both directions.


When one is using bond price reactions and trend changes for equity trades, use this timing disconnect to have better expectations. Meaning that once bonds bottom or top with the sharp move, it might take a few days before equities react, but once they do there will be prolonged drag in equities, as long as bonds remain within that same trend that the change was set into.


Examples of time delay on reaction bonds/equities:

Example 1: highlights on February 3rd, that while bonds plunged into strong downtrend right away and held, equities took almost two week to really give up and plunge as well. However the equities were already unable to create any fresh highs after the 3rd February. This highlights why perhaps one should be shorting rallies in such case.


Example 2: shows no time delay between reactions of each instrument. Both equally reacting with strong response. Sometimes there will be delay and sometimes there wont be, but the take-away of the example under is that when both bonds and equities react with strong relief-rally surge it creates even stronger back-bone for longs in equities over next days.



Example 3: shows that there are two different scenarios each time. In first bonds bottom out first with sharp bounce, creating a clearout-type bottom in equities few days after. Strong bounce in bonds therefore provided forward clue that equities might stabilize. Second example is where equities actually bottomed out first and bonds followed after. Often when bonds do not follow equities and keep selling-off while equities slowly move higher is when trust-worthiness of flows is the lowest as equities will weaken soon after, but not in this case.




Example 4: highlights a more common scenario where bonds top out ahead sharply with no recovery for 10 plus days, after which market tops out then equities and pulls them along the direction of bond markets.



Example 5:



Use case: Bottom/top rotations and trend continuation signals


As the examples above show, ideally one uses a combination of both asset classes when their movements are lagging each other (one is ahead, especially useful if bonds are ahead). This can provide more clarity on when to expect equity trends to end on the second lagging asset. However, selectivity is still needed to not mistake just any small push or selloff in bonds as a top/bottom signal but it rather has to be on good volatility.


Bottom-catching setup:


Conceptual example when bonds start to potentially bottom out after a strong push upwards and 15-minute trend rotation, and using that to time equity longs:


Additional to top/bottom signals there is one which is for most traders even more useful which is the trend-continuation signal. For example once bonds set into a bear trend or bull trend that keeps going it is a good idea to play equities along that direction and not fight the wrong side and wondering why are equities going the direction they are.


Trend-following setup:


A conceptual example of using the current downtrend in bonds to play along shorts in equities using liquidity swipes on the backside as entries and expecting further unwind in X large cap ticker:


Theoretical example of trend following in bear trend of bonds, using TSLA as the most extended large cap ticker on larger time frame to short into rallies :




SPY movements and bonds for that matter have been highly correlated 2022-23 so far


The dynamics between bonds and equities in a deflationary environment are not the same as in an inflationary environment where the market has to be often pricing in new changes. This means that inverse correlation can shift towards normal correlation due to conditions changing in the global economy. This is why over the past year the bonds and equities have been moving very much correlated. This is especially useful if one asset class provides signal ahead of the other and hance making it good aid in trading decisions, unlike in deflationary environment where that is much more rare.



Important forward-guide indicator


One additional reason why using 2Y/5Y bonds instrument are useful is because of their forward-signaling nature, not always of course but it provides signal every so often. Very few indicators in markets have the ability to do that since most are lagging indicators that just over-paint.

Weakness or strength in credit gives one often a forward indication of how institutional capital will consider the situation in upcoming weeks and how eager they might be to "push the buy button" on equities.



Going long SP500 or large cap stock while bonds are weak is not a good idea


When bonds weaken and stay in a firm bearish trend the chances of sustained rallies in SPY decrease. This means trying to pick the bottom in equities or being oblivious to what is happening in bonds is not a good idea. One is fighting the odds and likely to result in fake breakouts and failures to squeeze more likely.

The bond market has to firmly set a bottom and establish a few days of the up trend for equity longs to make sense, for the most of it. Of course, there are always specific tickers or sectors that are perhaps an exception, but for the majority the above said will apply.


Have you had longs in large cap tickers before, struggling to get them going for days or weeks? (Example of going long AMD after February 3rd)


If you rewind back those trades, you might be surprised in how many of those situations weakness in bonds has been telling you why they probably wont work. (Example of bond chart after February 3rd).


Pay attention to bond movements to find higher probability long opportunities in equities especially if you are swinging them. For large cap swing traders, tracking bonds is a must, while for intraday traders it is also very beneficial but it will vary from situation to situation


Bonds vs bond yields


All examples in the article are bonds underlying as asset (UST05Y in Tradingview for example), the setups would apply in an inverse sense on bond yields instrument (US05Y in Tradingview). Meaning just an inverted chart upside down of bond=bond yield at least in the current environment. If your charting platform only provides bond yield as an instrument that will do just as much, but it has a bit lower liquidity therefore might or might not lack a little bit of accuracy overall, although it is not that much of a difference.




Rate hikes and inflation fears need to settle completely for bonds to normalize until that further selloffs are possible this or next year


From a fundamental standpoint to make sense of credit market actions in the upcoming two years keep those key factors in mind that will help you to understand the movements quicker when they happen:


-if inflation upticks (hot CPI data) then central banks could raise interest rates more, increasing the yield on debt and decreasing the value of the bonds, pushing bond market to sell off more. Therefore watch the CPI prints and central banking decisions (FOMC) on monthly basis to understand why bonds react the way they do.


-if a new risk event happens (new proxy war, credit issue of a large institution, major institutional bankruptcy, etc...) the market will sell off credit as the potential for a cascade event (2008 style) increases. This can push bonds down for days or weeks, perhaps even more. It creates opportunity for continuous bear trend in bonds and provides the core structure to equity trades in such days or weeks.


-if unemployment numbers begin to rise and GDP starts to weaken globally and inflation downticks, yes that means central banks won't raise interest rates more, but it also means less demand, and lesser corporative earnings, which could mean murky or even negative reaction on credit over the long term. While this might not cause a quick selloff in bond markets it can act as a long term passive drag to the downside. Keep this in mind for this year very important: Just because rate hikes stop it doesnt meant the credit markets will stabilize for sure, because if economy starts to weaken significantly after hiking cycle and create credit events increase (bankruptcies), it can actually create even stronger bear markets in bonds than any rate hikes prior to that did.


The above three are the most likely scenarios we might face over the next two years either in single or multiple smaller-scale events. Adjust your expectations when trading equities in such cases. Because there is so much different scenarios as likely in air (none of which were present in prior 10 years) this creates a lot more uncertainty in credit markets and impacts all financial markets as a whole.


The holy grail of the long side: The QE (quantitative easing)



If and when we get a new QE somewhen down the road this or next year, if there was a credit event along deep recession happening, followed by FED stimulating with new QE- this would create a lift in credit markets and push equities higher as well.

If one patiently waits for such a thing to happen that is probably best window to extract solid longs in equities for multiple weeks or months.


But until then....be ready for a bumpy ride to the downside in credit/bonds. Can equity markets create large rallies before the major climax event followed by QE? Unlikely. Yes, many have speculated on the idea that markets have priced in recession and that a large short squeeze in equities could begin as too many are expecting the downside in the economy this or next year ("and it might be priced in"). Perhaps, but one would still think that is not the case, as credit remains weak and gets weaker the chances for a large rally in equities is much smaller than the actual chances to see equities slowly being dragged to the downside over the next 1-2 years with fresh macro lows, all the way until we see climactic credit-risk event followed by the introduction of new QE from central banks. That would be the actual bottom in equities most likely on a large time frame (3 plus months).


Some practical tips on how to implement tracking bonds on daily basis for your trading routine (it is not complicated at all):



Few points to establish:


1. Use 15-minute trend (due to PA quality don't use too low TFs), 15-minute time frame


2. Use either bond underlying or bond yields. The underlying bond is used as a direct correlation to SPY, meaning if the bond goes down the SPY goes down as well. Meanwhile, bond yields are used as inverse correlation, if yields increase the SPY should head lower. Use 2y or 5y bond yields as more sensitive instruments for the SPY/equities directional guide.


3. Use a 2y or 5y bonds instrument since it is well calibrated for intraday or swing trading for US markets, 10y and 30y tends to be a bit too slow.



On-time frame use: There is no need to use low time frame 1-minute charts, because the price action is not volatile enough on bonds, plus the equities usually do not react straight away to changes of movements in bonds, but rather have a delay. Therefore using 1 minute creates unnecessary noise in my view for this particular task, and makes more sense to use a 15-minute time frame of charts.


Whether one uses moving averages or technical highs/lows method to define what trend bonds are in is up to the individual, but keep in mind, it is all about trend and trend changes. It isn't about picking local tops or bottoms in bonds that matter very precisely, it is whether currently we are in a down or up trend in bonds, or have we bottomed or topped out by some sort of strong reversal action present over the past 3 days. Those are two key focus zones to pay attention to. Dont look too closely but also not too far out.


Conclusion



Hopefully, this article has helped to highlight why one should pay close attention to bonds in upcoming years and how to implement them on daily basis. In 70s traders and those engaged in financial markets payed a lot more attention to bonds movements than modern market participants, i believe that will mean-revert back to 70s as bonds will bring forward their attention due to inflation and high interest rate dynamics.


The article is relatively short to be as action-applicable as possible for those that do not have a solid fundamental knowledge of how markets function and are perhaps more technical analysis oriented.

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Brandon Lim
Brandon Lim
04 mar 2023

Thank you for the article! Really enjoyed the read.

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