Monday, March 2, 2009

Bond market optimism?


Here's a headline from this morning's news: "Stocks drop worldwide, Treasuries gain on concern economies are worsening." Stocks are indeed dropping, with the market cap of global equities down 57% from its high, and the S&P hitting a new multi-year low today. Rising prices for Treasuries typically reflect a market that sees less growth ahead, and in this market it makes perfect sense for Treasury prices to rise as equity prices fall.

But as this chart shows, that is not the pattern that has prevailed so far this year. Even as equities continue to hit new lows, bond yields have been ratcheting higher. Equities appear to be saying that the economy is getting worse, but Treasuries are saying that the outlook is improving.

One way to explain this divergence is to say that the prospects for economic growth have worsened (as reflected in lower equity prices and lower prices on corporate debt), but the prospects for deflation have lessened (as reflected in higher nominal yields and relatively stable real yields on TIPS).

If that is indeed the thinking behind the big moves in markets so far this year, I take that as a positive. The economy was facing three major risks at the end of last year: depression, deflation, and a big increase in future tax burdens. To the extent we can minimize or eliminate any of those risks that is good news.

P.S.: Commodity prices reinforce the message of Treasuries, since they have been holding pretty steady since the end of November, and in some cases have even risen. This suggests that economic activity is not deflating or collapsing.

11 comments:

M Miller said...

The contrary view as I understand it, from for example, Stephanie Pomboy and John Hermann (Hermann Forecasting), is that the bond market is looking through even a dire economy and pricing in inflation/over supply of treasuries in the future. In other words, a horrible economy but an even more horrible outlook for yields in the future based on inflating the money supply. My apologies to Pomboy and Hermann if I have misstated their viewpoints.

I'm not saying I agree with them, but putting forth a contrarian view of why equities can be down and t bond yields up.

Scott Grannis said...

Three things could drive up bond yields in this market: a) higher inflation expectations (or the equivalent, reduced deflation expectations) and b) higher growth expectations, and c) massive Treasury issuance.

I take the view to begin with that Treasury issuance fears have so far been overwhelmed by depression and deflation fears. If deflation and depression really took hold, the Treasury could sell bonds all day long and yields wouldn't rise.

But if you take away the depression and/or deflation fears, then everything changes. Issuance is no longer overwhelmed. But demand for Treasuries is undermined to the extent that deflation and depression risks decline.

Reading the tea leaves, it seems to me that the big move this year has been concentrated in nominal Treasury yields, with very little happening to TIPS yields. Breakeven spreads have moved from projecting deep deflation to now expecting only a littled deflation.

The fact that real yields haven't really risen tells me that the market is not pricing in higher growth expectations (real yields tend to track growth expectations).

So I think that declining deflation risk is the dominant factor.

dave said...

Scott,
I'm having trouble understanding the concern about deflation with gold near an all time high, If anything my concern is inflation . Am I missing something ?

brodero said...

Thanks Scott for pointing out the
better economic data in this difficult environment.I believe you
are right.

Mark Gerber said...

Hi Scott,
I'm wondering why you never post or review the long term data on net consumer debt. Even when removing record low home euqity, comsumers have more debt as a percent of disposable income than ever before. Isn't this at the root of the crisis we face?
Thanks,
Mark

Scott Grannis said...

dave: good point about gold. Gold and bonds have been telling diverging stories for some time now. I've thought that bonds were clearly underestimating the inflation that gold was pointing to, and overestimating deflation risks. The bond market is not always right. Bonds underestimated inflation risk all throughout the 1970s for example, even as gold was rising.

Gold is likely signaling not only rising inflation risk but rising fear of a global financial and/or political breakdown.

How to separate geopolitical risk from inflation risk in gold prices is an art form that I don't claim expertise in.

bob wright said...

Scott,

You said "Rising prices for Treasuries typically reflect a market that sees less growth ahead"

Can you pls explain why this is so?

thx

Mark said...

Scott,
Been a fan of your for about six months. Always a pleasure. Question: if bond prices are falling and stocks are falling, where is the money going to?

Scott Grannis said...

Bob: The bond market has a knee jerk reaction to changes in the outlook for growth. If the economy gets weak, the bond market automatically expects interest rates to fall (and bond prices to rise) because a weak economy supposedly means lower inflation and an easier Fed.

This is not always the right thing to expect, but more often than not, that is how the bond market reacts to news about the economy.

Scott Grannis said...

Mark: For one, the money never actually moves from one market to another, even though that's what most people believe happens. What really happens is that investors try to shift out of one asset and into another, and that causes relative prices to change.

If bond and stock prices are falling, then it is reasonable to think that people are trying to move to cash, or to gold, or to some other supposedly "safe" asset.

Don Harrison said...

Other credit markets -- investment grade corporates, high yield debt, secured bank loans, libor -- reinforce what Scott says about rising government yields indicating a return to some normalcy and growth. All of these markets -- especially high grade debt -- have improved markedly from the Armaggedon-like conditions that prevailed in the fall.