Green shoots the bond market is ignoring

So much winning! Global equity markets are pushing higher, and many are at all-time highs. Chinese equities and the yuan are perking up. The threat of tariff wars is receding. Industrial commodity prices are turning up. Housing starts in the US are soaring. Consumer confidence is high. Financial market fundamentals are very strong.

So why are yields on Treasuries so low? Why are real yields on 5- and 10-yr TIPS near zero?

The following charts flesh out the details and speculate on what is driving this amazing apparent divergence between stocks and bonds.

Chart #1

As Chart #1 shows, US stocks have outpaced Eurozone stocks by roughly 85% since the bear market ended in March 2009. Moreover, Eurozone stocks until recently had failed to advance for almost 5 years. News last month of a trade deal with China pushed both markets to new high ground.

Chart #2

As Chart #2 shows, the US market has been outpacing Chinese equities for years. News last month of a trade deal added over 10% to the market value of Chinese equities while also boosting US equities.

Chart #3

As Chart #3 shows, the Chinese yuan has risen almost 5% since last September, when rumors of a trade deal first surfaced. The chart also tells us that the Chinese central bank is not trying to control or defend its currency by buying or selling its foreign exchange reserves. Sentiment and capital flows are therefore the key to the yuan's value, so the fact that it has risen in recent months is proof that the trade deal is a positive for China. Rising equity markets worldwide say that the trade deal is good for just about everyone, for that matter. What's good for China is good for everyone, since it means more trade and more prosperity.

Chart #4

That's a very good thing, since world trade has been stagnant ever since Trump's trade wars started in early 2018, as Chart #4 shows. We should soon be seeing a pickup in global trade and global industrial production, both of which have been stagnant or weak for some time now.

Chart #5

Industrial commodity prices, shown in Chart #5, have jumped 7.5% since news of the trade deal broke. This is likely due at least in part to the market's expectation that world trade and manufacturing activity will revive shortly. It is also good news for emerging markets, since they are very dependent on sales of commodities.

Chart #6

December housing starts blew past expectations (1608K vs 1380K), as was foreshadowed by a surge in the homebuilders' sentiment index, as shown in Chart #6. The US housing market looks to be on solid and fertile ground, and that all but precludes a recession for the foreseeable future. Indeed, this could be a precursor to a broader pickup in the US economy, which has been growing only modestly this past year.

Chart #7

Chart #7, Bloomberg"s Consumer Comfort index, recently reattained the high-water mark it set in the boom years of the last 1990s. 

Chart #8

Incomes are rising, jobs are growing, and fewer and fewer people are getting laid off. In fact, as Chart #8 shows, the number of initial unemployment claims as a percent of the workforce is at an all-time low. That spells "job security" and all these things are boosting confidence. 

In addition to the above economic "green shoots," key financial market indicators tell us that liquidity is abundant, the Fed is non-threatening, and the bond market has confidence in the outlook for corporate profits. What's not to like?

Chart #9

2-yr swap spreads, shown in Chart #9, are excellent leading and coincident indicators of financial market and economic health. Swap spreads both here and in the Eurozone are low, and that in turn suggests that liquidity conditions are excellent, systemic risk is low, and the outlook for economic growth is therefore positive. 

Chart #10

Chart #10 shows 5-yr Credit Default Swap spreads, which are a very liquid measure of generic corporate credit risk and a excellent indication of the market's confidence in the outlook for corporate profits. Spreads today are very low; in fact, things haven't been this good for a long time.

Chart #11

Chart #11 shows actual corporate credit spreads by credit quality for the past 24 years, and they confirm the message of Chart #10. The private sector of the US economy is in great shape.

Chart #12

Chart #12 is the best way to track the stance of the Federal Reserve's monetary policy. It strongly suggests that two things the Fed has a lot of influence over—the shape of the yield curve and the level of real short-term yields—have consistently preceded every recession in the past 60 years. An inverted yield curve and high real yields are what crush economic activity. Today, however, the yield curve is upward-sloping and real yields are zero. Fed policy is thus absolutely non-threatening. Liquidity is not being restricted, and borrowing costs are low. Inflation is also low. It's monetary nirvana.

So with all this good news, why are Treasury yields so low?

Chart #13

As Chart #13 shows, 10-yr Treasury yields today (1.8%) are just half a point above their all-time lows of 1.3%. Not only that, but 10-yr Treasury yields today are below the level of consumer price inflation, which has been averaging 2% or a bit more for the past three years. Whatever is going on, the world is paying very high prices for the safety of Treasuries. At the very least that is a good indicator that the bond market is not overly confident about the outlook for the future.

Chart #14

Chart #14 compares the 2-yr annualized rate of growth of GDP (which gives us a sense for what the market believes is the prevailing rate of growth) to the real yield on 5-yr TIPS (which is an excellent proxy for the prevailing level of real yields as well as the market's expectation for the effective stance of Fed policy over the next five years). Two things to note: real yields tend to track GDP growth rates, and the current level of real yields suggests the market is not expecting any meaningful pickup in US growth—nor any meaningful change in the Fed's current accommodative monetary posture—for the foreseeable future. Indeed, it wouldn't be hard to look at this chart and conclude that the bond market is expecting growth to slow down further.

Chart #15

Chart #15 shows the equity risk premium, which is the difference between the earnings yield on stocks (i.e., the inverse of the PE ratio) and the yield on 10-yr Treasuries (the world's proxy for long-term safety). That's the yield premium the market demands for taking on the risk of equities. That premium today is about 2.7%, and that's quite a bit above the average of the past 60 years. I take that as a sign that the stock market is still very cautious, as is the bond market. Which goes directly against the message of credit spreads, which are very tight and thus reflective of optimism. 

Chart #16

According to Bloomberg, the current PE ratio of the S&P 500 (which is calculated using profits from ongoing operations) is a bit over 22. For the past 60 years it has averaged about 17. Chart #16 is based on a different calculation of corporate profits, since it uses corporate profits economy-wide, which is drawn from the National Income and Products Accounts. Nevertheless, it gives about the same answer: PE ratios are above-average, but still well below levels that later proved to be excessive valuations (e.g., 1961-62 and 2000). In other words, relative to the prevailing level of Treasury yields, current PE ratios look fairly attractive from a historical perspective.

Chart #17

I'll close with Chart #17, which compares the ratio of copper to gold prices (blue) to the level of 10-yr Treasury yields (red). Over the past decade, these two utterly distinct variables have shown a remarkable tendency to move together. The rationale for that is that the ratio of copper to gold prices is a proxy for changes in global economic growth conditions: stronger growth creates more demand for copper, while at the same time reducing demand for gold, and vice versa.. The recent uptick may be a precursor of more to come. If global growth picks up as many of the above charts suggest, then the copper/gold ratio should rise, and 10-yr Treasury yields should rise as well.

Bond investors would be well-advised to buckle their seat belts in preparation for a descent to lower bond prices. Stock investors who fret that an equity bubble may be forming should be braced for a bumpy ride higher.