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In 1999, the U.S. Federal Reserve started raising interest rates.
The central bank hiked its benchmark rate from 4.75% to 6.5%. A year later, the market crashed 38%.
Fast-forward seven years…
In 2006, the Fed raised rates from 1% to 5.5%. The market fell 55% the following year.
Today, central bankers are raising rates again. And it’s a warning sign that the bull market might be nearing its end.
Regular Daily readers know I’m bullish on the markets.
But let’s be serious… Eventually, it’s going to end. All bull markets do.
Since this bull market is the second longest in history, I’m looking for signs of a top.
I don’t see many yet… But if history is any indicator, the bond market should be the first place to look.
Let me explain…
A Caution Sign
Bond prices are generally stable… and the bond market doesn’t fluctuate much. But when it does… watch out.
The charts below show the past 20 years of the Dow Jones Equal Weight U.S. Issued Corporate Bond Index and the Dow Jones Stock Index.
As you can see, the bond index fell more than 10% only twice in that span: in June 1999 and in September 2006. Both times, the stock market topped within the next year.
Today, the bond index is down only 3% from its peak in 2016. But it might be headed for an even bigger drop…
Rising Interest Rates
Bonds are starting to fall because interest rates are back on the rise.
You see, bond prices move in the opposite direction of interest rates. In other words, when interest rates go up, bond prices go down (and vice versa).
After years of historically low and negative interest rates, central bankers around the world are now reversing course.
The Fed raised its benchmark rate by 0.75% over the past 12 months—a 300% increase.
The Fed also wants to sell some of the bonds it owns. That’ll put more supply into the market and push interest rates even higher.
But the Fed isn’t the only central bank raising rates…
- The European Central Bank plans to pare back its stimulus program—which could result in a rate hike in the European Union.
- The Bank of Japan is struggling to keep rates below 0.1%.
- The Bank of Canada is expected to raise rates this month.
- The People’s Bank of China raised short-term rates earlier this year.
These moves have caused interest rates to rise across the globe. And that spells bad news for the bond market.
The Canary in the Coal Mine
Rising interest rates will hurt all bond prices. But the market I’m watching closely is the corporate bond market (see the Dow Jones Bond Index above).
You see, investors consider government bonds to be risk-free. That’s because the U.S. government will never default. It can always print its way out of debt.
But since corporations can default on their bonds, traders demand higher yields. This rate is called the “default risk premium.”
As the risk-free rate rises, so does the default risk premium.
And it won’t take much for interest rates to rise enough to drive corporate bond prices down by 10%.
All it would take is the current corporate rate of 3.25% rising to 4.35%. That’s only a move of 1.1 percentage points.
That’s what I’m looking for…
If a rate rise drops bond prices by 10%, we’ll get serious about preparing for a bear market.
Don’t do anything now. Continue holding quality stocks… It’s still a bull market.
I’ll keep you updated when bond prices fall and help get you ready for a bear market.
Nick Rokke, CFA
Analyst, The Palm Beach Daily