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Bond yields are falling, falling, falling . . . but global equity markets simply don’t seem to care:
Global stock prices have rallied 6 per cent over the past six weeks, while global bond yields have fallen a collective 25 basis points, according to Citi research. That’s rather contrary to their relationship over the past decade, or so. And yet, we have seen divergences before — specifically in the dreary days of 2009.
But we’ve also, says Citi’s Robert Buckland, seen them rather earlier:
. . . de-coupling between bond yields and stock prices is not unusual. In fact, a similar event in 2004 contributed to Alan Greenspan's famous Conundrum speech in 2005. On most occasions the equity market has been proven "?right'. This would mean the current episode should resolve itself through higher government bond yields, not lower global stock prices.
Citi count eight previous episodes where bond yields have fallen but equities have rallied, and found that the stock market turned out to be "?right’ on five occasions.
In other words, after each episode it was bond yields that rose to catch up with stock prices — not stock prices which fell to catch up with bonds.
What to make of the current divergence then?
Buckland reckons the bond market is tracking weaker economic momentum, while equities are looking at strengthening earning expectations. So far, so standard — but why the asset-tinted goggles? :
We think operating leverage is the answer. Positive operating leverage means companies can turn an uninspiring economic recovery into a healthy profits recovery. Bond yields can follow the L-shaped recovery in some parts of the economy… but equities can follow a V-shaped recovery in EPS… As companies contain costs any growth in revenues makes for big gains in profits. Macro investors, who focus on GDP, often underestimate the impact of operational leverage on EPS.
And Buckland thinks that based on this explanation, the current decoupling between bonds and stocks is not too dissimilar to what happened to make Alan Greenspan so confused in 2005.
Back to Buckland:
[Back then] The recirculation of FX reserves into government bond markets, plus the search for yield from other sources, helped drive a divergence between bond yields and stock prices. At the start of 2004 Asian FX reserves totaled $1.65 trillion. Given that many Asian economies needed to buy US dollars to fix their exchange rates, much of this money ended up in US government securities. By the end of 2004 Asian FX reserves were 30% higher, at $2.15 trillion. They rose to $2.4trillion in 2005. This amount was equivalent to about 50% of US federal government debt at the time. Today Asian FX reserves total about $4.7 trillion5, just under 60% of US government debt.
Just as there was a new and large buyer of government bonds back then, we have another one now "“ US and European central banks. Talk abounds of further Quantitative Easing. Perhaps low fixed income yields tell us less about economic prospects and more about technical buying of government bonds.
So how was the de-coupling resolved back then? As we show in Figure 10 it was via bond yields eventually rising, not stock prices falling. From October 2005 to May 2006 stock prices rallied another 10% while global bond yields rose by 35 basis points.
As for who’s right now, Citi are erring on the side of history:
Our rates strategists, Mark Schofield and Robert Crossley, believe that bond yields will rise. They believe the sustained global economic recovery, the historically low level of bond yields and gloomy fiscal outlook will all contribute to eventually drive yields higher. Their forecasts are for US bond yields to rise by 75 basis points by the end of 2010 and a further 70 basis points by the end of 2011. German 10-year yields are expected to rise by 60 basis points and another 15 basis points over the same periods.
One for the bond bubble meme, then.
Related links: The myth of the great bond bubble – Pragmatic Capitalism Do US bonds resemble dot come stocks? – The Big Picture One almighty decoupling – FT Alphaville, 2009
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