Bond traders are the smartest guys in the room.

This is something I learned early on in my career, and it’s worth sharing right now.

This isn’t to say the actual people trading bonds are geniuses and never lose money (I’ve seen some bad ones for sure). But I’m making a statement more about what the bond market is pricing in for the future.

Simply put, the bond market has a way of forecasting or discounting economic trends much better than the stock market… because bonds are forward-looking.

So when we think about the current environment – and about what the Federal Reserve is saying it’s about to do (which is raise rates substantially) – I’ve been focusing on the price action of the bond market.

And it’s not lining up with the consensus. The bond market is calling the Fed’s bluff – and quite frankly, so am I.

What do I mean by this? And what does it mean we should expect this year? Let me explain…

Inflation is at 40-year highs. Fed Chairman Jerome Powell just told Congress he will fight inflation by raising rates. And many Fed members are saying the Fed is going to raise rates two, three, or even four times this year.

And yet… bonds have hardly moved. In fact, they rallied for a bit after Powell’s speech. That’s not the price action of a bond market expecting runaway interest rates.

So, what’s the bond market discounting? What’s it pricing in for the future?

As I say often, the “what” or “why” something will happen isn’t what I speculate on (although I have plenty of guesses)… It’s the price action and the when that helps you set up successful trades.

So, let’s start there.

The last rate-hike cycle began in December 2015. The Fed started raising interest rates incrementally over the next three years. It was a slow start – only one hike in 2015, one hike in 2016, then three hikes in 2017.

For the most part, as interest rates went up, stocks went up. And notably, bonds “bought” what the Fed was saying then. That makes sense… Higher rates signal growth, and stocks follow, which makes a strong economy. So all was in sync.

The rally only ended when the Fed tried to get aggressive in 2018. It raised rates four times, and the stock market broke down at the end of the year. You probably remember that correction. The Fed quickly reversed its stance (admitting it was wrong) and began to cut rates.

The important part is what happened next. Stocks rallied as they cheered a new dovish policy stance. But that time, the rally was running headfirst into a trap – because in early 2020, bond traders were about to send a major warning signal…

At its January 2020 meeting, the Fed noted that economic growth was to continue, the trade war with China was diminishing, and there were signs of stabilization in global growth. It noted COVID-19 was a risk, but, at that time, it was on the backburner.

Forget what you know now about COVID-19 and the crash – it’s easy to be a 20/20 hindsight trader. What I want to focus on is the spread between stocks and interest rates during this period.

Most important is that stocks rallied for almost three weeks after this meeting (into February 19, 2020, to be exact). Interest rates did not. The bond market was not buying the growth story or the stabilization story.

This was the trap.

The bond market was discounting trouble ahead. Was it discounting a virus? Probably not. But it was discounting lower growth, not higher growth like the Fed wanted us to believe. So stocks (and the Fed) got it wrong, and bonds sent the warning.

You can see it in the chart below. And now, here we are again…

This shows the U.S. 30-year interest rate going back to 2017. Again, look how rates made a lower high from November 2019 into the January 2020 meeting before the crash. This was the trap if you compare it with stocks, which kept rallying into February.

This price divergence was a major warning… And we’re seeing the same thing now.

Look how interest rates topped out in March 2021, made a lower high in October, and then another lower high this month.

Does this chart of long-term interest rates look like the picture of economic growth? It sure doesn’t to me.

Think about it like this… If the move up in rates from early 2020 to March 2021 was based on higher growth and higher inflation expectations, then what is the move down since then showing us? It doesn’t look good.

Simply put, bonds are sniffing out something yet again that equity investors aren’t. Bonds are leading, and we need to pay attention to this price action. It was worthwhile to do so in 2020… And it’s likely to be again over the next few weeks.

As the great trader Paul Tudor Jones famously said, “Prices move first, fundamentals second.”

Back in 2020, I didn’t know about a virus, but I knew something was wrong in the market based on how I look at things… and that proved to be correct. I traded the top and crash based on this analysis in my Ten Stock Trader newsletter.

My trades and calls for market moves are based on price and time… and most important, how price reacts into certain time periods – like right now. As traders and investors, we don’t deal in certainty… we deal in probabilities. The trades I make are based on these probabilities, and then we assign risk to it and manage it accordingly.

And right now, the probabilities are very high – based on price and time – that volatility is going to explode in 2022.

Good trading,

— Greg Diamond, CMT

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Source: Daily Wealth