Tuesday, August 7, 2012

The bond/equity disconnect

Very low yields on Treasury securities—and on most developed country sovereign debt, for that matter—are symptomatic of a market that holds out very little hope for growth, and a market that believes that central bank accommodation for an extended period is necessary to (at worst) keep the economy from sinking into another recession or (at best) pump up growth a little. There has been a fairly good correlation between equity prices and interest rates because of this perceived connection between weak growth and low interest rates—until late last year, that is. In the U.S. we now see equity prices approaching post-recession highs, while bond yields are still extremely low. What does this mean? 


One possible answer is that even though equity prices are nearing a post-recession high, they are still depressed compared to earnings and thus reflect a market that is very reluctant to see any good news on the horizon. According to Bloomberg, the trailing 12-mo. P/E of the S&P 500 is now 14.2, and the expected P/E is now 13.1. Both those ratios are substantially below the 16.6 average P/E ratio over the past 50 years.



And P/E ratios are very low considering that corporate profits are very close to record high levels compared to GDP. Very low P/E ratios are thus best interpreted to mean that the market is very pessimistic in regard to the future potential of profits. In a sense, the market is priced to a significant decline in profits, and that would imply that the market believes that growth is going to be miserable in coming years. This market is not optimistic at all. It was extremely optimistic in 2000, as we now know, when P/E ratios were extremely high but corporate profits as a % of GDP were relatively low; back then the market was priced to a continuation of robust rates of growth for as far as the eye can see. Today, in contrast, the market is priced to doom and gloom.


As this last chart shows, the bond market is not entirely oblivious to the improvement in equity prices. The 5-yr, 5-yr forward breakeven inflation rate that is derived from TIPS and Treasury yields (the Fed's favorite measure of inflation expectations) has moved up more or less in line with a stronger equity market in recent weeks, and is now at a one-year high.

My interpretation of all this is that equity prices are improving not because the economy is getting stronger, but because the economy is not deteriorating to the extent reflected in bond yields. Since the economy is not getting materially stronger, the bond market still expects the Fed to stay on hold for a long time, and so Treasury yields remain extremely low. But now the bond market is sensing that the risk of a Fed overshoot—i.e., not reversing its accommodation in a timely fashion—is rising, and that means that inflation could be somewhat higher in the future than the market had been expecting. Treasury yields are not going to rise meaningfully (thus "catching up" to equity prices) unless and until the economy proves to be much stronger than it is currently perceived to be.

15 comments:

brodero said...

Different markets but,,,
10 year treasury yield April 1954 2.29%...10 year year April 1959 4.12%
S&P Index April 1954 28.26...April 1959 57.58...up 104%...

sgt.red.blue.red said...

I think you've got it nailed, Scott.

Dr William J McKibbin said...

The low bond yields are a signal -- moreover, even Dr Bernanke has stated that interest rates will remain low through 2014 -- folks, the picture is not good...

Dr William J McKibbin said...

PS: Note that Dr Bernanke is being cited in the WSJ as arguing for alternative measures of well-being in society -- Dr Bernanke is essentially admitting that well-being is declining despite actions to date by monetary and fiscal policy-makers over the past four years -- again, the story is bad for those who care about well-being...

Benjamin said...

As always, interesting and thoughtful commentary by Scott Grannis.

The question with which Grannis has to wrestle: Why have sovereign yields been falling for 20 years, and if trends continue, does not most of the developed world enter zero bound (Japanland)?

At zero, central banks can no longer stimulate through lower interest rates---that is like fighting a flood with firehoses. Rates are already low. The Taylor Rule is calling for -2 percent interest rates.

Regardless of your politics, regardless of your favored economic policies, the reality is that at zero bund central banks cannot stimulate using conventional tools.

National governments can help by lowering structural impediments, but really is the USA going to wipe out the USDA; throw open our borders to immigrants; shrink jobless benefits; wipe out ethanol; and shrink the defense-VA-homeland security budget to 2 percent of GDP? In our lifetimes?

If you say wait until structural impediments come online, you are essentially saying what until Hell freezes over.

The market is saying that central banks are still uncomfortable with using quantitative easing (QE), although it will have to become the conventional policy tool of the present and future.

Until the Fed gets aggressive, we will see reflections in a not-do-distan mirror, that of Japan.

Dr William J McKibbin said...

@Benjamin, the usual outcome in situations such as where the US is today, is to leverage a crisis in order to restructure -- World War II activated a major restructuring of the US economy -- so did Sputnick -- regretfully, the restructuring since the Berlin Wall fell over 20 years ago has been in a direction to save the military industrial complex and its bankers benefactors -- the only question is whether future restructuring will be away from, or toward, the current "war time" economy -- let's face it, the military industrial complex is fighting to save its role in the US economy -- so are the banks -- if I were a betting man, I would bet on world war -- however, I still think that there is a real chance of creating a vibrant "peace time" economy once and for all (much like China has) -- unfortunately, the creation of a growing "peace time" economy may require violence to get there -- the most likely outcome remains world war -- the elites will set that up behind the scenes -- the good news is that world war can be profitable -- better to keep our eyes on dividends and profit than on trying to control the elites...

RichmondG30 said...

No worries. As soon as the S&P sheds 500 points all will be back in balance.

Squire said...

Being new to bonds, I was surprised to learn that U.S. Treasury auctions are not ever fully sold; that the primary dealers pickup the bonds that investors don’t buy. Evidently, this has been going on a long time and it amounts to a lot of bonds. According to econoday.com, PDs bought 54% of the $24 billion auctioned.

I wonder two things. Wouldn’t the amount of Treasuries held by the primary dealers become so high that the FED would have to buy them off their hands with another QE? And isn’t this a form of monetization if the primary dealers pay for the bonds with base money?

Scott Grannis said...

I think that what you are seeing is Primary Dealers buying bonds on behalf of their customers, which is very common. They don't make a habit of accumulating large Treasury positions; their business is built on transactions and the occasional speculation.

Dr William J McKibbin said...

I cannot imagine buying US treasuries under these conditions -- if interest rates go up at all (and they will), the bondholder is immediately bleeding red -- the downside risks are real, and the upside potential is none...

William said...
This comment has been removed by the author.
William said...

After 9/11/2000 when the stock market appeared to have made a low, Ken Fisher noted that the subsequent rally was a false rally because bond yields didn't rise as they would in anticipation of stronger GDP growth and lower bond demand and greater inflation.

Looking at your graphs, the reaction of bond yields during this market rally, strongly suggests that this equity market rally is for REAL!!

Benjamin said...

Squire and Scott--

In fact. Treasury sales have been oversubscribed for years, and Treasuries are, in a sense, rationed off to buyers, but not by price.

By all appearances, we are in a huge ocean of capital.

Dr William J McKibbin said...

Word to the wise -- now is a good time to do "equity deals" rather than "cash deals" in business -- the value of money, and especially the dollar, is too uncertain -- equities are different and currently are undervalued -- these days, firms are busy buying back common shares all over America -- now is the time to acquire equities one the cheap before society figures out what is happening and equities become very expensive once again...

William said...

Sorry, I meant "After 9/11/2001..."