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By New_Deal_democrat October 14, 2014 1:35 pm
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The message of the bond market

 

Stock prices are making a nice downward spike.  Bond yields are also declining smartly.  While a lot of energy has been spent trying to decipher the message of stocks, what is the message of bonds?  The answer, I believe, is both good news and bad news.

 

Here's the bullet-point version:

 

  • since bond yields are a long leading indicator, and stocks a short leading indicator, bonds are looking further out into the future
  • an air pocket in stock prices is not unexpected, since for the last year, stocks have gotten ahead of corporate profits, whereas over the longer term, the two tend to converge
  • declining bond yields in a very low inflation environment such as now foretell weakness in the near future (i.e., over the next 12 months or so)
  • declining bond yields - if significant enough - foretell a rebound in activity further in the future, i.e., more than 12-18 months away
  • whether the shorter term weakness translates into an actual downturn is usually forecast by a significant increase in the spreads between corporate bonds and treasuries
  • spreads have not widened significantly to date, so no downturn in the near term is forecast, but on the other hand bond yields have not declined significantly enough to suggest a strong rebound thereafter

 

Now let's take a more detailed look.
 
As I've pointed out in prior commentary, the bond market's relationship to stock prices changed since 1998.  During the disinflatinary 1980s and 1990s up until then, bond yields were in a secular decline, increasing only with Fed rate hikes, usually based on fear of higher inflation. Bouts of inflation (and Fed tightening) are bad for stocks.  The bottom line is, bond yields and stock prices tended to move in opposite directions.

Since that time, we have moved from a disinflationary environment to a low-inflation, even occasionally deflationary, environment.   In this environment, bond yields and stock prices have more often than not moved in the same dirrection.  During those periods when there was no worry of deflation, it has meant that the economy has been doing well. 

After the taper panic of mid-2013, bond yields shot up by over 1.5%, with Treasuries peaking at just over 3%.  Earlier this year, the bond market gradually took back its overreaction, with bond yields moving in the opposite direction from stocks - i.e., down by over .6% - while the S&P 500 advanced by over 20% YoY.

As the graph below shows, the inverse movement of bond yields and stock prices has in the last month reversed:

Bond yields and stock prices are now moving in unison again. Both are seeing weakness in the immediate future, with low inflation or outright deflation rather than inflation being the primary fear.

But, aren't lower bond yields ultimately a good thing?  Yes, since "the price of money" goes down.  An excellent example is the repeated refinancing of consumer debt since the early 1980s every time mortgage rates in particular have made new lows.

Bond yields are a long leading indicator, as originally recognized by Geoffrey Moore decades ago. Yields on bonds tend to move down early in economic expansions, and rise in the latter part of expansions.  Let's look at them from 2003 to the present:

Note that in the expansion of the 200s, Treasuries bottomed first, followed by corporate bonds about a year later.  Both rose significantly off those lows for several years before the 2008-09 recession began, with corporate bond yields spiking immediately before and into the recession, as there was a flight to the safety of Treasuries.  Once Treasuries made a new low, and corporate yields began to decline, that was a signal that in about a year, the recession was likely to have ended.

Note that the same pattern appears to have been playing out in this expansion.  Treasuries bottomed in 2011, and corporates bottomed in 2013.  Now let's focus on the yield spread between corporates and Treasuries:

Note that corporates and Treasuries are moving in the same direction now.  The spread has barely widened.  Unless that spread widens to at least 2.4%, and corporate yields start to rise vs. Treasuries continuing to decline, I see no immediate dange (in fact, this looks very much like the 2006 decline in tandem of corporates and Treasuries).

Finally, on a related note that does not involve bond yields, when we average stock prices over an entire quarter, they tend to follow corporate profits with a lag of several quarters.  While the relationship can blow out for significant periods of time, over the longer run it is a strong relationship.  Note in graph below, showing this relationship, stock prices have not followed the much more tepid YoY increase in corporate profits since 2012:

 
 
So at least a temporary downward spike in stock prices is hardly out of line with this relationship.

In conclusion, the message of the bond market is both good and bad. Like many other indicators I track, the message is that we are past the midpoint of this expansion, and weakness in the next 12 months is forecast.  On the other hand, bonds are not forecasting any imminent downturn.

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