Here's what bonds are trying to tell us

There's a long-held belief on Wall Street that if you want to understand what the smart money is doing, look at the bond market. That's not to say the most successful investors favor bonds over stocks, but rather that trends among bond investors have historically been more reliable indicators of future economic developments.

It's generally accepted that stock prices and equity benchmarks are more susceptible to emotional decisions and therefore prone to larger irrational swings.

The more than $40 trillion in the U.S. bond market, on the other hand, tends to be considerably more boring. Lower returns and less excitement can result in more logical decisionmaking.

Plus, the largest pools of capital on the planet — government pension programs, sovereign wealth funds, institutional endowments — tend to have major allocations to bonds and some exceptionally smart people pulling the strings.

Here are a few clues about what may lie ahead for the economy based on a longer look at the bond market:

A quick refresher: Parts of the yield curve began to invert in 2018, when longer-term bonds paid lower yields than shorter-term bonds. Earlier this year, the yield on the 2-year U.S. Treasury note rose above the yield on the 10-year Treasury. Widely considered to be the most significant, the 2-year vs. 10-year inversion triggered a cavalcade of recession calls.

At this point, however, you can safely assume that Uncle Joe won't be conversing about inverted yield curves around the Thanksgiving table. The Federal Reserve has driven down short-term interest rates with three cuts in three months since late July. Ten-year yields, meanwhile, have risen from 1.43% in early September to nearly 2% this month. Previously inverted, then flat, the yield curve has begun to steepen.

The amount of yield investors receive on different qualities of bonds are a useful indicator to gauge concern about the profitability of U.S. companies. Corporate bonds with a Double-A or Triple-A rating are deemed to be safe investments and pay lower yields. Bonds with lower credit ratings, Triple-B for example, carry more risk of default and compensate investors by offering a higher coupon. When the economic outlook is positive, credit spreads remain tight because even lower-rated companies are perceived to carry minimal risk of default. When concern starts to build, credit spreads widen substantially.

So where are credit spreads currently? They look awfully similar to two years ago and have actually narrowed considerably since the start of 2019. This suggests a better economic forecast than was the case earlier in this bull market cycle.

As of late October, high-yield corporate bond funds (meaning bonds rated Double-B or worse) had received more than $20 billion of net new investment inflows year-to-date. While it's difficult to pinpoint the exact reasons for this surge, it represents a shift from recent years. High-yield funds experienced net outflows in each of the past two calendar years, including the category's worst-ever annual outflow ($46 billion) in 2018. Whether it's bond investors looking for more yield or equity investors looking to diversify, there's clearly a comfort level with lower-quality bonds. That's not a sentiment we typically see when investors are pessimistic.

It's important to keep in mind that monetary policy by the Fed and other central banks around the world directly impact bond yields and investor behavior. Most historical analyses of bond market trends and subsequent economic patterns were not conducted during periods of massive stimulus like we've seen in the past decade. Still, bond markets have a tendency to be ahead of the curve when it comes to identifying a potential slowdown.

Positive developments with global trade negotiations, better-than-expected corporate earnings, and multiple Fed cuts have all led to higher equity prices. The momentum for now is entirely positive. That said, those looking for signs of economic weakness would be wise to review the bond market for proof.