Do we believe bond markets? And if we do, what's the bounce in stock markets all about?

Monday 4th July 2016

Do we believe bond markets? And if we do, what's the bounce in stock markets all about?

ref:- " Bond Markets Have a Message About the Economy That Stock Investors Might Not Want to Hear", Bloomberg Markets

Some of the traditional market guides of yesteryear can look a little simplistic in the modern era .... quaint perhaps, and a little dated. But in principle, the old logic regarding economies, interest rates and markets is still completely sound. Put very simply, if an economy and corporate performance are on the wane (STOCKS DOWN), then rates should go lower to re-stimulate things (BONDS HIGHER)..... and of course vice versa. It's just that special circumstances can meddle with used to be taken as basic truths, and these days we've got plenty of special circumstances to muddy the waters.

Take the last week, for example: A hugely influential geopolitical event (Brexit) taking place against a financial background beyond the experience of all market participants (ultra-low or negative rates). If the immediate market reaction to the shock of the Brexit vote made complete sense (Stocks sharply lower / Bond prices up and yields down), why have stocks bounced so significantly even as the political fallout in the UK promises to make things even more difficult for the global economy? The S&P 500 and the Nikkei 225 have almost regained pre-Brexit levels. So too the FTSE 250, an index that more accurately reflects the UK domestic scene than the higher-profile FTSE 100  --  a measure top-heavy with international stocks and those in the global mining and resources game ( and one that closed on Friday 3.7% higher than in did on June 23rd, incidentally).

That the rush for safe-havens has given further impetus to soaring bond prices and their falling yields should come as no surprise, even if buyers of UK Gilts will surely soon have to consider the inflationary implications of dramatically weaker sterling at some point. Safe-haven seeking wouldn't ordinarily encourage wide buying of stocks, but evidence suggests that bond markets offering such meagre or negative returns have caused investors to put money into stocks even in this precarious environment. The result is that bonds and stocks have been moving higher together, at least in the short-term.

Dated thinking or not, this is deeply counter-intuitive over any length of time and the suspicion is that something's got to give. The thrust of Bloomberg's article is that with yields the world over setting new record lows it's unlikely to be the bond market. The 10yr term premium  --  which is a gauge that measures the premium required by investors to hold long-term debt rather than a series of short-term debt purchases that total the same period  --  is in negative territory and at a 50yr low. It represents falling expectations of growth and inflation  --  which is fine for bonds of course but does not fit well with stock prices moving higher.

Moreover, the suggestion is that some people have been much too quick to put the ramifications of the Brexit vote behind them. Hopes of the UK remaining in the EU despite the Leave vote, or of the EU offering a generous deal when it does, are misplaced. A recession in the UK, the world's 5th largest economy, increases the chances of a global recession.

Not convinced? Just look at the bond market, say the analysts. The relentless flattening of the yield curve (i.e. the reducing gap of long-term rates over short-term) is historically a pretty good indicator of increasing chances of a recession. In fact, Deutsche Bank run one model which compares 10yr Treasury yields to 3-month equivalents and it now puts the probability of a recession in the US at 60% in 12 months.

Not many others admit to being as pessimistic as that but however much credibility you ascribe to such a theory, at the very least it seems reasonable to question the rationale of taking a plunge in stock markets.