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By New_Deal_democrat March 1, 2018 10:29 am
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A change in economic seasons? (Part 2 of 2)
In part 1 of this post, I mentioned that the relationship between stock dividend yields and bond yields (in particular, the 2 year treasury yield) had reversed recently for the first time in nearly a decade. For 50 years, bond yields were higher than stock dividends. After the great recession, stock dividend yields rivaled bond yields to the point where stock ownership seemed like a slam-dunk. And for the last 9 years, it has been. Now it looks like we are headed for a period where bond yields are again higher than stock dividends by a significant percentage. 
 
But there is another, even more fundamental change that may be starting.
 
Looking back over the last 100 years, there have been 6 secular "eras" of stock vs. bond returns:
 
1. 1920-29: declining bond yields and sharply rising stock prices.
2. 1929-48: bond yields and stock prices at first fall together, then bond yields stagnate as stock prices recover.
3. 1949-66: stock prices rise sharply as bond yields also rise -- but a strong move in one correlate with a strongly *opposite* move in the other.
4. 1966-82: stock prices stagnate as bond yields rise.
 
While I can't create graphs for the first 3, I can create one for 1971-82 on FRED, showing that significant moves in bond yields typically produced an opposite move in stock prices:
 
 
Since then, we have had the two more secular eras, which recapitulate the first two:
 
5. 1982-98: declining bond yields and sharply rising stock prices. 
 
 
6. 1998-present: bond yields and stock prices rise, then fall together, then bond yields stagnate as stock prices recover and ultimately make new highs.
 
 
We may be transitioning to a new era which recapitulates the 3rd: in which rising stock prices correlate with rising bond yields, but *within which,* a strong move in bond yields produces an opposite strong move in stocks.
 
Here is what happened on several days during the recent V-shaped correction: a steep selloff was triggered by a sharp *rise* in bond yields:
 
 
Note that, beginning about January 27, stocks and bond yields transitioned to becoming largely mirror images of one another.
 
This is something that has almost never happened in the past 20 years, since 1998. 
 
My take on this is there are times when the stock market is more concerned about a spike in inflation, and the Fed having to stomp on the brakes in order to stop it, vs. when the stock market is more concerned about an oncoming deflationary recession *whether or not* the Fed engages in any active tightening. For those of you who may be interested, this entire 100 year pattern fits nicely with Kondratieff's idea of a 60 year interest rate cycle.
 
A recent post at "Market Armor" makes much the same point with some excellent graphs which I am reproducing.
 
Their graph of historical P/E ratios vs. Treasury yields suggests that the inflection point for inflation vs. deflation fears is at about a 4.5% yield on the 10 year Treasury:
 
 
They have several more graphs showing in more detail the correlation between bond yields and stock prices over the last 20 years. First, the 3 month correlation:
 
 
And also a 3 year correlation (thus the short term correlation that started in 1998 doesn't show up clearly until the 3 year mark in 2001. Note the scale is inverted):
 
 
If the change in the stock/bond relationship we saw briefly in February is the harbinger of a long-term secular trend of rising bond yields, stocks become a much better long term investment. Further, if the 1950-80 secular era is a guide, in economic each cycles, stocks will appreciate more during periods of sideways or slowly rising vs. quickly rising bond yields.
 
Are we in that new era yet?  Come back and ask me whenever the 10 year bond yield goes over 3.04%. It may not be coming this week, this month, or even this year, but I strongly suspect we will see it within the next 1-3 years.

 

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