Australia | Aug 18 2010
By Greg Peel
At the height of GFC fear in 2008, the yield on the US ten-year Treasury bond plunged from 4% to 2%. Earlier this year, when the US economy appeared to be in better shape, it returned to 4%. But following the European crisis, Chinese slowing and a recent run of ever weakening US economic data, it is back at 2.6%.
Bonds and stock prices will always fluctuate contrarily throughout cycles in a perpetual search for equilibrium. In the simplest of terms, the two are alternative investments, which is why the average “balanced” investment portfolio diversifies risk by holding a weighting in both.
While a government bond rate is often classed as the “risk free rate”, this is not at all the case given the market ascribes a “price” to those bonds based on expectation of being safely paid interest and repaid the principle, and on the simple arithmetic of demand and supply. The higher the price, the lower the yield and vice versa. Bonds become expensive (low yield) when the market is shying away from risk, which is usually a time when stock prices become cheap. They become cheap (high yield) when the market is happier to take a bigger risk for higher reward on stocks.
Thus typically, bond yields are low when stock markets are low or, more importantly, when the market foresees lower stock prices ahead.
It is this last point which has Wall Street worried. It made some sense for the US ten-year to fall to 2% at the height of the GFC, because stock prices plunged. It made sense that by early 2010 that yield had recovered, given the stock market had spent most of 2009 recovering a fair amount of ground. But the S&P 500 last night closed not far from its level at the beginning of 2010, yet the ten-year is back at 2.6%.
That's why the stock market is worried. The ten-year bond yield is screaming double-dip – not just in GDP but in stock prices as well. But like everything in markets, the US bond market doesn't necessarily have to be right.
National Bank head of research Peter Jolly suggests US bond yields have fallen for three major reasons throughout history: (1) Systemic concerns and a rush by investors for the safety of government bonds; (2) cyclical weakening in the US economy; and (3) a decline in longer term inflation expectations. Note the following chart:
Note that there have been four major dips in yield over the period, with the 1992 recession unlabelled. The only other unlabelled dip is the fifth one – the one we are now experiencing. The graph shows examples, Jolly notes, of any or all of the above reasons at work. The general down-trend reflects the long term decline in inflation expectations (point 3) ever since central banks decided to control inflation following the inflation spikes of the seventies and eighties.
The three labelled events reflect systemic concerns (point 2) and all other fluctuations reflect economic cycles (point 1).
Were this latest fall in yields to reflect systemic concerns, it would be accompanied by equivalent falls in the prices of risk assets. Yet stock prices are stagnant and commodity prices have been rising (in bulks, through the roof). And anecdotally there's not a general belief in a return to the crises that sparked the GFC.
So strike point (1). But there is a lot of talk about a possible economic double-dip and a grave fear of deflation given weaker US data, particularly in relation to the all important US consumer. So tick points (2) and (3). That the Fed has seen reason to modestly ease monetary policy further (by reinvesting maturing loans) only adds to concern.
In other words, the bond market is telling us we're about to go back down again.
The NAB economists have nevertheless joined a growing band of commentators who suggest the bond market has simply got it wrong. The rapid V-bounce of the US economy was always going to wane as fiscal and monetary stimulus waned, and as the front-loading impetus of inventory rebuilding wanes. The extent of indebted and unemployed households underlying the US economy meant there was never going to be as robust a recovery as appeared to initially be the case.
But nor does NAB subscribe to the double-dip argument. The economists believe a “grinding” US recovery will continue, which is really what has been happening all along if you take out the noted stimulus. The problem is, however, it may be difficult to convince a wary market otherwise. Fear begets fear, and low bond yields are making Wall Street fearful. The only way the bond market could be snapped out of it, suggests Jolly, is for either US economic data to suddenly turn positive or for the Fed to seriously step up quantitative easing.
Jolly can't see either occurring.
There is a risk in standing against the herd, and there is also a risk that on current trend, US economic data will likely get weaker before they get stronger. The US manufacturing PMI is set to drop into contraction territory and that would send bond yields lower still.
From the US perspective, Jolly suggests the bond market should be heeded in the near term but seen as providing an opportunity in the longer term horizon (which translates to buy stocks, but don't buy them yet before cheaper valuations appear).
But there is also an Australian perspective. Low US bond yields are dragging Australian bond yields lower as well, yet there are no fears of a double-dip in the Australian economy. Indeed, the stock market has breathed a sigh of relief that the RBA appears to be on hold for a few months now, with global uncertainty helping to balance out the potentially inflationary impact of low unemployment locally and high commodity prices globally. The futures market is pricing in only a 25 basis point hike from the RBA in the next twelve months based on interest rate yields, but most economists expect much more. NAB's forecast is for another 100 basis points in hikes beginning early next year.
Thus while Jolly sees a more medium term opportunity as provided by low US bond yields for US investors, after further likely near term weakness, that opportunity is even more notable for Australian investors given US bond yields are also forcing Australian bond yields lower, despite the two economies facing rather different outlooks.
