Wednesday, August 15, 2012

The bond/equity disconnect resolves in favor of equities

Last week I noted the significant disconnect between rising equity prices and very low and falling bond yields. Low bond yields are symptomatic of dismal economic growth expectations, but rising equity prices point to improving expectations. One explanation for this disconnect that I offered was that equities are not necessarily pointing to a strong economy, but rather to an economy that is now seen to be less weak than it appeared to be a month ago. Bond yields remained low, I suggested, because the outlook for the economy is still weak enough to warrant extremely low short-term interest rates for at least the next several years, much as the Fed has been telegraphing. 

This week the disconnect between the two markets seems to be resolving in favor of equities. 30-yr Treasury yields are up sharply—nearly 50 bps—in the past three weeks, with most of that rise occurring in the past 12 days. Meanwhile, 2-yr Treasury yields are up less than 10 bps, which suggests that the market has not made any major adjustments in its expectations for near-term Fed tightening. (2-yr Treasuries can be thought of as the market's expected average Fed funds rate over the next 2 years.) Most of the action in recent weeks has come at the long end of the curve—from 10 to 30 year—which is consistent with my theory that the outlook for the economy has become less dire, and so the risk of deflation has been reduced considerably (the bond market typically views a very weak economy as posing deflation risk). But the economy has not improved enough to warrant any major change in the outlook for Fed policy. I'll stick with my view that equities are rallying not because the economic outlook is becoming healthy, but rather because it is becoming less awful—don't forget the drumbeat of expectations calling for the economy to now be in recession. This is still a reluctant rally.


Dr William J McKibbin said...


marcusbalbus said...

guys like you have been carried out on gurneys for the last 5 years. thank god you don't manage anyone's money.

mmanagedaccounts said...

Guys like Scott have been rewarded in a big way over the past 3 years. Having done very well for themselves, they don't have to manage anyone's money.

Equities are underpriced and government debt is overpriced so the disconnect ought to be resolved in favor of equities.

The big unknown is how soon.

Scott Grannis said...

Marcusbalbus: you come to a very wrong conclusion based on very limited facts, such as the composition of my portfolio. That I have been wrong on the direction of interest rates is one thing, but I have also been very right on a number of other things, such as equities, apple, REITs, corporate bonds, junk bonds, and emerging market debt.

Joe said...

This is something where people with exact opposing views on politics can come to the same conclusion on market expectations. I think Scott and I could not be farther away from each other politically than possible within the US framework, but I wholeheartedly agree with his views on the stock and treasury markets. For the next 6-12 months it will be the triumph of the optimists.

brodero said...

How about this JPM issues 5 year paper with a 2% pays a dividend of 3.4% on its common stock...stockbuybacks???

Benjamin said...

I think we will know the stock market is in a rally-mode when we start to see management LBOs and the like.

As Vigilante and Redleaf in their book "Panic" pointed out, being a shareholder is a type of weak ownership. Management is strong, not ownership. Management will seize control of companies, through LBOs, if companies are undervalued. That will mean rallies on Wall Street.

We are not seeing a lot of LBOs. Ergo, for now, the market seems about right in its price.

Unless we get a growth-oriented Fed, I fear we will do a Japan-lite. What the Bank of Japan has proven is that seemingly no matter how long a bank crushes inflation, the economy never responds. Investors never regain confidence. Japan has had structural reforms since 1992, to no avail.

The Fed is an independent public agency, ergo with each passing year, becomes more and more insular, and with ever more exalted and deified mission statements. This happens at all public agencies--think Defense, USDA or Housing and Urban Development--but is worst at independent public agencies, removed was they are from much public understanding or accountability.

The DJIA is where it was in 1999. Will it be higher in 2019? Not if the Fed stays the course.

William said...
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