Wednesday, January 5, 2011

Higher bond yields go hand in hand with stronger growth


Treasury yields and equity prices are facing upward pressure as the economic news gets better. Bond yields and equities have been moving more or less in tandem for most of the past year, and both have been good indicators of sentiment regarding the strength of the economy (which is not unusual at all). Deflation fears have also played a role, as suggested by the bottom in both yields and equities in late August, just before the Fed first floated the idea of another round of quantitative easing; a concerted QE2 effort to vanquish deflation has succeeded, and that has helped lift the economy. As deflation fears are replaced by rising inflation expectations (the 5-yr, 5-yr forward breakeven inflation rate embedded in TIPS has risen from 2.0% last August to 2.9% today), and as double-dip expectations are replaced by stronger-than-expected economic news (e.g., declining unemployment claims, strong auto sales, solid ISM numbers, a blowout ADP report, and rising commodity prices), bond yields and equity prices are rising.

The forces of recovery have been building for 18 months, and they are now being reinforced by rising confidence, which in turn has been boosted by a very favorable change in the fiscal policy climate. Despite the magnitude of QE2, I think its effects have been mainly limited to quelling deflation fears rather than directly boosting growth. After all, there still is no sign of any outsized growth in any of the money supply aggregates, and QE2 can hardly claim to have lowered long-term borrowing costs for anyone. We now have a virtuous cycle at work which will be very difficult to derail. Higher bond yields won't kill growth because they are the by-product of stronger growth.

Full disclosure: I am still long TBT and equities at the time of this writing.

11 comments:

Benjamin said...

I think Wall Street will "catch up" to thought leader Scott Grannis in 2011, and start to believe in this recovery.

I think we see 13,000 on the Dow in 2011. Read somewhere that money flow are into equity funds again. PE's are not too high, and profits could rise nicely.

This could be a long, good ride for equity and property markets. Bring it on.

John said...

The top performing sector during the month of December was financials...they doubled the return in the S&P 500. The trend is continuing in this first week of 2011.

This trend is still in its very early stage and will last for several years. It will not go in a straight line...markets never do. But I continue to believe the financials will outperform the S&P 500 in 2011 and will be good investments for several years...or until the Fed raises rates enough to end the economic expansion.

This bodes well for the equity markets as a whole. Financials leading the markets higher in my cheap opinion is extremely bullish.

Scott I particularly enjoyed reading your 2011 forcast.

Public Library said...

Benji,

Wall St analyst are all bullish. Read their trade rec's.

Bullishness is at a feverish pitch despite the media. The media is last to get on board. When they do, bail out quick.

We haven't resolved anything structural in the economy. We are still promoting spending over investment, debt issuance versus austerity, and wage growth is non existent.

Next comes higher food/commodity prices via dollar degradation and the middle class gets another shellacking.

I am linger equity than before but won't ride this pony for very long.

Benjamin said...

Public Library-

The money flows have actually been out of equities (trimtabs is source) until recently.

Analysts are pumping and dumping, like they always do. Forget them.

The money flows say to me that investors like stocks sgain. Mr. Mo Mentum is very powerful in today's world. Stocks go up, so people buy more.

This rally has more legs than a centipede, I say.

Benjamin said...

Another rally on Dow today. Commodities acting iffy.

Possible scenario: Commodities have rallied due to investor interest. And investors may become more interested in equities and real estate.

End of commodities rally?

John said...

Benj,

I could be wrong but I don't think the rally in commodities is done. Perhaps the easy money has been made here but I suspect they go higher still this year but maybe not as far or as quickly as last year. Natural gas is very interesting. Shale in particular.

Pub,

There are always problems. When all the problems are gone it will be past time to sell. Glad to know you have been long some equities. I hope you did very well.




The recent buying is hugely institutional...not hot money traders flipping options. Cash is yielding nothing and the bull market in treasuries is largely over. A rotation is occuring into equities and it is just beginning. Corrections will occur, as always. Those using them to accumulate good quality equities should be nicely ahead of MM funds by yearend.

Everyone should keep in mind that equities are by definition risk assets. As we saw last summer volatility can be high. As Pub has correctly pointed out there are structural problems with our economy yet to be resolved. However I believe the potential rewards are worth the risk, as they were last year.

Scott has forcast 10 to 15% increase in the S&P 500 for 2011. If corrections are used for buying those numbers could possibly be exceeded. Do your homework and trade carefully if you invest. And don't be afraid to consult a professional if your experience in markets is slight. This blog is also an excellent source of economic information that I have found very helpful. Good luck to all.

Benjamin said...

John-
Hey, I could be wrong too, but if money starts leaving commodity ETFs, then commodities could snowball downhill.

Right or Wrong, Mr. Mo Mentum is the biggest player on the field today.

Lots of money seems to pile into favored classes, long after it makes any sense. Ergo, money will be pouring into equities for several years on the merits, and then a couple years more on the momentum.

Commodities will be last year's starlet, now washed-up, and turning tricks in the gutter for $10 crack-coke bags.

Well, it may seem that way to investors in gold.

mmanagedaccounts said...

According to the IBES Model stocks are -55% undervalued. That undervaluation is pushed to an artificial extreme by artificially low interest rates, but even if rates are normalized stocks would still be 32% undervalued.

The extremely conservative Value Line Appreciation Model shows 7.7% compounded growth potential for the S&P 500 over the next five years.

Earnings estimates are continually being increased on average.

There's plenty of liquidity available to markets (MZM is growing at an annualized 8% rate), and the Fed is making certain money is plentiful.

There's no reason stocks shouldn't go higher, EXCEPT there may be too much optimism. No, we are not even close to euphoria, but the level of optimism among professionals and non-pros is worrying me. We really ought to have a very strong year, but it could get a little rocky in the short-term.

Kelvin said...

Could someone tell me what would happen to equities if the USD strengthens? Will equities sell off like commodities are starting to now?

John said...

Kelvin,

There are lots of takes on this and others may want to weigh in but here's mine:

I don't pay too much attention to the dollar, up or down, unless the move threatens to be large. Last summer was such a time. Many short term traders trading huge positions can move equity prices at the margins based on small currency moves but I have found it extremely difficult if not impossible to time consistently. I stopped trying long ago.

Most individual investors IMO should pay far more attention to longer term economic trends whie focusing on industry or company specific financial data.

Everyone is different. My way is certainly not the only way. It just works for me.

Scott Grannis said...

Kelvin: I would approach this from the other direction: what would happen to the dollar if equities continue to rise? I think the dollar would strengthen if the economic news improves more than expected, and I would expect the equity market to move higher on that sort of news. The dollar is like the price of admission to the U.S. financial markets, when there are only a limited number of tickets available. If US investments look more attractive on the margin, then the dollar would tend to rise since more would want to participate.