Major Moves

Traders have been caught between optimism and pessimism regarding the trade negotiations between the United States and China for months on end. When the negotiations seem to be going well, traders move money out of the safety of Treasuries and into the stock market. Conversely, when the negotiations seem to be going poorly, traders move money out of stocks and into Treasuries.

Today, traders started moving money back into Treasuries after Commerce Secretary Wilbur Ross said the U.S. and China are "miles and miles from getting a resolution." This increased demand for Treasuries pushed Treasury prices higher and Treasury yields lower.

The 10-year Treasury yield (TNX) confirmed this turnaround by completing a bearish wedge continuation pattern as it broke below the up-trending support level that has served as the bottom of the consolidation range the indicator has been in for the past month. This is a potential red flag for equity traders. If money managers continue to shift more and more capital to Treasuries, the stock market is going to have a difficult time sustaining its short-term bullish uptrend.

Chart showing the 10-year Treasury yield
www.finviz.com

S&P 500

Even though Treasury yields fell today, they did not drag the S&P 500 with them. The S&P 500 remained virtually unchanged from yesterday as it formed a small spinning top doji. This lack of movement tells me that Wall Street is comfortable in the holding pattern it has been in all week as it waits for more earnings and economic news.

I am still watching resistance at 2,675.47 (the high from Jan. 18) and support at 2,600 to confirm either a bullish or bearish breakout on the index, but it appears like we may be consolidating in this range for a while.

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Chart showing the performance of the S&P 500 Index
www.finviz.com

Risk Indicators

The bearish trend we have been witnessing in Treasury yields has had some positive spillover effects. Lower yields are making stocks – especially dividend-paying stocks – look more attractive in comparison. They are also pushing mortgage rates down, which is boosting the housing sector.

The 10-year Treasury yield (TNX) has a positive correlation with the 30-year mortgage rate. When the TNX goes up, mortgage rates tend to rise. When the TNX goes down, mortgage rates tend to fall.

This positive correlation is driven largely by banks and other financial institutions. If banks are looking for long-term investment opportunities that will provide a reliable yield, they can buy U.S. Treasuries, which carry little to no risk, or they can issue mortgage loans, which carry more risk.

To compensate for the additional risk they are taking on when issuing mortgages, banks will charge a risk premium. Typically, the risk premium between the TNX and a 30-year fixed-rate mortgage is somewhere around 2%.

This means that, if the TNX is 2%, a 30-year fixed-rate mortgage is likely going to be close to 4% (2% TNX + 2% risk premium = 4% 30-year rate). Similarly, if the TNX climbs to 3%, the 30-year rate is likely going to climb to somewhere around 5%. In other words, the higher the TNX goes, the more expensive mortgages become. Of course, the opposite is also true. The lower the TNX goes, the cheaper mortgages become.

Traders watch the value of the TNX because they know that cheap mortgages boost growth in the housing sector. As the TNX has been falling, so have mortgage rates. The 30-year fixed-rate mortgage has dropped from 4.94% on Nov. 15 to 4.45% today – providing a boost to homebuilders. 

Homebuilder stocks have had a good month so far, and that trend continued today as the TNX completed its bearish continuation pattern. Companies like D.R. Horton, Inc. (DHI), Beazer Homes USA, Inc. (BZH) and Lennar Corporation (LEN) all climbed higher as expectations of higher home prices and more home buying demand caused traders to upgrade their expectations for the industry group.

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30-year fixed rate mortgage average
Federal Reserve Bank of St. Louis FRED Charts

Bottom Line: Pros and Cons

Fluctuations in Treasury yields are tricky because there are pros and cons associated with each swing. Lower yields are great for the housing sector and for general borrowing in the U.S. economy, but they are often a signal of investor sentiment becoming increasingly risk averse. Higher yields make it more difficult to borrow, but they provide better returns for fixed-income investors and are often a sign of strong economic growth and confidence.

Currently, it appears the financial markets are finding a happy medium of allowing yields to decline as the Federal Open Market Committee (FOMC) walks back expectations of future rate hikes while still pushing stock prices higher. But the balance is a delicate one that could be easily disrupted.

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