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By New_Deal_democrat September 11, 2014 6:56 am
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The stock/bond divergence dwarfs the bond conundrumette
There has been a flurry of writing in the econoblogosphere during the last week or so about the new "bond conundrum."  Here's a piece by Prof. James Hamilton, and here's a very good compilation of recent posts by  Lambert Strether.


The original "bond conundrum" was a term coined by Alan Greenspan, who was surprised that as he raised short term rates in 2005 and 2006, long rates fell.  The argument is that a similar phenomenon is playing out now.  Aside from the fact that the Fed hasn't raised rates at all as of the present, a look at the yield curve suggests that, compared with 2004-06, what we have is merely a "conundrumette."


For comparison, via Stockcharts' dynamic yield curve tool, here is the yield curve in late 2004 (light red) vs. late 2006 (dark red):



Bond yields went from steeply positive to outright inverted (a dire portent of things to come), while stocks (right side, between vertical lines) boomed.


Now here's similar graph from August 2013 (dark red) to the present (light red):



Note that this is the exact same scale.  Yes, short term rates have moved higher, but just barely, while long term rates are only slightly below where they were a year ago.  Like I said, at best this is a conundrumette.


Unlike 2004-06, the only significant move in bonds has come from January of this year, when long bonds briefly yielded over 3%.  In fact, when we compare 5 year and 10 year treasury yields over time, we can see that both have moved almost in unison, with the exception that the 10 year reacted more strongly to the "Fed taper" talk of mid-2013, and has counter-reacted this year:



It will not take much convergence to place both yields right back in sync, compared with the pre-taper time period.  In other words, the long bonds may have overreacted in 2013, and corrected that this year.


Another way of looking at the same information is to look at 5 year yields subtracted from 10 year yields over time:



Facing the 1990, 2001, and 2008-09 recessions, the Fed reacted with assymtercally strong easing, causing the difference in yields between medium and long dated bonds to balloon out past 1% from its more typical range of 0.5% or less -- and especially so following the Great Recession.  In this perspective, it simply looks like the difference in rates between 5 year and 10 year bonds is returning to its long term normal range.


But if there is only a bond market conundrumette, there is a major divergence between the stock and bond markets.


First, a history lesson. During the disinflationary 1980s and 1990s, typically the stock and bond markets moved in opposite directions.  Here's a graph from 1982 through 1998, showing that typically a downturn in bond yields (think "refinancing")  was associated with higher stock prices:



In fact, in the graph above the only major exception was in early 1987, when stocks kept soaring in the facing of rising bond yields -- until the October 1987 crash.


But beginning in 1998, most often bond yields and stock prices have moved in the same directions.  What this tells me is that we went from a disinflationary environment (good) to one where the chief concern was outright deflation (bad).


Since 1998, there have been three significant exceptions to this rrend of stocks and bond yields moving in the same direction.  Two of them occurred in the year immediately preceding the last two recessions, where bond yields fell in the face of rising stock prices.  The third occurred in the 2004-06 "conundrum" years, which were the strongest years of that expansion.



During 2004- 06, deflation was not a concern.  Rather, there were relatively stable bond yields with briskly increasing business profits, and stock prices to match.


The period from the beginning of this year to the present is the 4th such exception to the rule since 1998.  While long term rates have been falling, stock prices have again soared. In fact, this is the most severe decoupling of all.  To put this in perspective, let's show it on the same comparison graph from 2004-present:



The era from 2012 to the present roughly resembles that of 2004-07, when the stock market rose strongly in the face of flat to slightly rising bond yields.  Eventually, in late 2006, bonds yields began an extended period where they failed to make a new medium term high, nor a new medium term low. In 2007, yields turned decisively lower, and stocks then followed.


If we take from the bond conundrumette that what is really going on is that long bonds overreacted to Fed taper talk, and are now correcting themselves, then we have a situation in stocks vs. bonds much more like the latter part of 2004-06. Bond yields are relatively stable, without making new highs or new lows, while stock prices are increasing dramatically.


If this relationship plays out like it did a decade ago, then as the effects of consumer refinances peter out, corporate profits will begin to fall, consumers will begin to cut back, and an economic downturn will follow.


But not just yet.

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