Friday, January 20, 2012

The bond/equity disconnect


Over the past several years, bond yields have correlated pretty well with equity prices—yields rise and fall along with the ups and downs of the stock market. Higher stock prices reflect increased optimism (or less pessimism) about the future, and bond yields move in synch because a more healthy economy increases the odds of higher inflation and a tighter Fed. Most of the time the correlation between stocks and bond yields has been 0.6 to 0.8, interrupted with a few relatively brief periods of negative correlation, as can be seen in the two charts below. Over the past few months, we have once again entered one of those periods where the correlation has gone to zero. Equity prices are up, but bond yields remain very low and relatively stable. As the above chart suggests, either bond yields should be at least 100 bps higher, or equity prices should be a lot lower.



In my view, this disconnect reflects a buildup of tension in the market—something is likely to break pretty soon. Bond yields have been depressed because risk-averse investors have been seeking shelter from a potential Eurozone collapse that might trigger another global recession/depression/deflation. But equity prices have been rising because in the meantime, while the world waits for the Eurozone to implode (and we've been waiting for at least 18 months now), the U.S. economy continues to improve. Bonds are the doomsday trade, while equities are more realistic about what's happening right now.

I can think of an alternate explanation, but it's not very convincing. Maybe bond yields are low because the market is absolutely convinced that no matter what happens to the economy, inflation is going to be very low for a very long time, and central banks, and particularly the Fed, are going to remain at or close to their "zero bound" for as far as the eye can see. To counter this explanation, I note that break-even spreads on TIPS reflect inflation expectations to be in a 2.0- 2.7% range, which is pretty close to the average rate of CPI inflation over the past two decades (2.5%), and during that time 30-yr bond yields have averaged 5.5%. In other words, I find no evidence to suggest that bond yields today are priced to deflationary concerns, so their low levels therefore more likely reflect an intense risk aversion on the part of investors.

In any event, it's unusual and I think unnatural for capital markets to be so schizophrenic. The assumptions driving bonds and stocks should ordinarily reflect the same world view, but these days they don't seem to.

My money is on bonds catching up to stocks—bond yields are more likely to rise than stock prices are to fall. What could trigger this? Maybe the Fed bows to the same realities that are driving equity prices higher, and informs us that with the economy doing better on the margin, the Fed mostly likely won't have to keep yields at zero for the next several years as the market currently believes it will. Or maybe Greece finally executes its default, but the world does not come to an end (after all, a huge default has been fully priced in for a very long time, so it should not prove surprising or disruptive when it finally happens). Or maybe the simple passage of time without anything disastrous occurring will do the trick—markets can't stay priced to disaster forever if a disaster doesn't occur.

10 comments:

Donny Baseball said...

There is still a large and influential QE3 crowd out there. A Credit Suisse guy was on Tom Keene's program today saying QE3 is coming in the spring. Granted this guy was talking about the Fed going in for another round of MBS purchases, but for market psychology purposes Fed intervention is Fed intervention. Nobody thinks the Fed is packing up the tent.

Benjamin said...

"In any event, it's unusual and I think unnatural for capital markets to be so schizophrenic. The assumptions driving bonds and stocks should ordinarily reflect the same world view, but these days they don't seem to."---Scott Grannis.

Both of me agrees with Scott on this.

Actually, I think the bond investors are fearful the USA does a Japan.

You had three CPI readings in a row at zero or negative, and yet there is huge unused capacity in the economy, but still the Fed frets and pettifogs about inflation, and the right-wing threatens o execute Bernanke if he stimulates the economy (before the election anyway).

The bond market rightfully is detecting a Bank of Japan approach by the Fed.

puffer said...

Scott,

What would QE 3 do to yields here? Can the Fed override the market at the long end?

Michael Meyers said...

I think the answer for low bond yields is financial repression from the Fed, i.e. negative real yields on bonds for some time. It's a form taxation.

Benjamin said...

BTW, the Cleveland Fed calculates the inflation expectations curve.

Scott Grannis should really, really take a look. inflation is deader than Jimmy Hoffa, judging from the expectations.

http://www.clevelandfed.org/research/data/inflation_expectations/index.cfm

John said...

Rather than QE3, raise the minimum wage. That would shift some corporate profits to wage earners who would go out and spend it. Mankiw works harder (so he said) when he makes more and so does most everybody else.

If a business can't pay a living wage, then they don't have a viable business model.

Benjamin said...

Dr. Perry, over at Carpe Diem, just ran the Cleveland chart on inflationary expectations. Basically, there ain't none.

This would explain the "low" bond yields we see now. They seem low, but the public knows inflation is dead, and deflation is possible.

Certainly, if you are investor, deflation is very possible. You see what has happened to stocks and real estate in the last 10 years in the USA? Og course, deflation is possible. You see Japan?

Get rid of deflationary anticipation among investors, and we can get this economy going. That means the Fed stops dithering, and gets aggressive about growth.

If you thought stops and real estate would rally, would you keep your money in bonds at one percent? Or even gold?

Donny Baseball said...

John-
Pure unadulterated poopycock that is. 1) People won't work harder b/c they know they have the force of law on their side, 2) it won't transfer corporate profits to folks with higher propensity to spend - corporate owners will look to automate or reduce labor inputs in direct response, 3) it'll put out of work a segment of the labor force that don't have the skills to warrant the higher wage. This is all economics 101. And what does the minimum wage have to do with the "Bond/Equity Disconnect"? This is such a left-field suggestion.

sgt.red.blue.red said...

Benjamin;

It would be interesting to see the Cleve Feds 10 year expected inflation forecast versus actual inflation, plotted, to see how accurate the forecasts turned out to be.

If someone is fearful, I can't see buying long treasuries and risking principal when I could by short.

I'd rather wait until sometime like June of 2007 in the last cycle to buy the long UST's, for a trade.

Have been buying US and foreign index mutual funds, since August, on down days

P.S. Jimmy Hoffa II lives, history may not repeat, but it ...

John said...

Donny Baseball: You brought up QE3. I suggested what might be a more productive alternative.