Treasuries versus Stocks
What can drive stocks? What can drive treasuries? In theory there should be some scenarios where stocks go up, and some where they go down, and the same idea should be applicable to treasuries.
In a simple world, these should be the 4 scenarios.
The GREAT ROTATION would be current heavy favorite. Stocks go up as bonds fall in price.
The NIRVANA scenario would be what we had for much of this year. Stocks and bonds doing well together. This is the best scenario for corporate bonds (particularly high yield bonds) as spread and yield both move in same direction.
The RISK OFF trade is one we are all familiar with, though it seems to be a distant memory.
The MESSY trade seems the most far fetched one, where for some reason treasuries and stocks sell off.
If we look at the market today, the market seems to have assigned some probabilities to various scenarios.
The market seems to have ruled out 2 possibilities completely. There is an almost universal acceptance that stocks must go higher. It isn’t euphoria it is something a bit different. More like some resignation that the world has changed and stocks are entitled to grind higher every day because either the news is good, or the current news isn’t good and we will get more QE and eventually the news will be good.
At the same time, there is a growing consensus that bonds can’t go higher in price, at least not treasuries. That view isn’t quite as widely held as the view that stocks can only go up, but it is gaining some traction.
Corporate bonds seem to be left in the lurch a little. Will they perform like treasuries, with nothing but downside, or like stocks or somewhere in between?
But before looking into corporate bonds, what do these scenarios really need to play out?
Bonds, or at least the 10 year treasury seem pretty simple to figure out. We can talk about growth, GDP, QE, tapering, etc., but the reality is there are two primary determinants of 10 year yields. These are inflation (or inflation expectations) and the Fed Funds rate.
The Fed Funds rate is key. This looks at YOY CPI compared to the Fed Funds Effective rate (the rate it is actually trading at). You can see that from 1990 until 2009 it was rare for Fed Funds to be lower than inflation (as measured by CPI). There was a period in 2002 to 2003 where that occurred, but the Fed was raising rates and was just a little behind.
All that has changed. This is crucial I believe. Not just for the analysis we are currently doing but for anything that looks at rates as a benchmark. Many things, such as the Fed’s own measure of “risk premium” on stocks rely on comparing bond yields to such things as dividend yields. The question is “are the measurements valid?” Should the measurements have always been versus inflation and not treasury yields, and it just happened that for so long treasury yields matched moves in inflation that it didn’t matter?
If you accept that the Fed has changed how it sets interest rates, and that they are far less focused on “transitory” measures of inflation than in the past, then the shape of the curve becomes much more important.
If the past, inflation and fed funds moved by and large in the same direction. The fed was an inflation fighting entity. That is far from clear now. So you need to balance the real risk of inflation, with bond math. The shape of the yield curve is more crucial than ever.
It is possible for the curve to get ever steeper as inflation expectations increase, but if the Fed is anchoring the front end, the move will be muted as too many will play the forward yield game all the way out the curve. While most pronounced 5 years and in, it is not negligible further out the curve.
So from rate perspective, Fed policy and the shift in mentality is more important factor than ever before, and this Fed intends to keep rates exceptionally low for an exceptionally long time. That is very supportive of treasuries.
And now let’s look at inflation.
We already saw the “miss” in CPI today.
This is one of the GDP PCE Deflators. The Fed’s self-proclaimed favorite measure of inflation. The one they seem comfortable letting it rise to 2%. It is nowhere close to 2% and my guess is that it is running lower this quarter than last quarter based on a couple of simple checks.
The CRB index has been weak. It had bounced after the gold sell-off but is back to trending lower.
A quick screenshot of a random assortment of commodities shows virtually all are down this quarter to date.
So any inflation isn’t coming from commodities. In spite of the “great” NFP data release, we aren’t seeing real wage inflation pressures.
The average hourly earnings YOY change is under 2% and has come down from some signs of life early in the year. This comes from that “great” NFP report, which frankly was only okay and mostly reduced fears that the job market had been falling off a cliff, rather than any real “jump for joy” strength.
Not bad numbers, but nothing out of the ordinary for the past 3 years, so it would be surprising if wage inflation was suddenly a material concern at the Fed or for the markets. The markets are almost desperate to have wage inflation, but it doesn’t seem real.
Which leaves housing inflation. That is real. That area is doing well and at 40% of the CPI it is important, but it has less influence on the Fed’s favorite measure and will struggle to stoke inflation fears alone. Without wage inflation (still hard to get with so many people around the globe willing to work at a fraction of the price) and the lack of commodity inflation, the “inflationary” pressures seem more wishful thinking by the “growth” crowd than reality. Growth and Inflation may be less correlated than many realize.
I will spend less time on the equity drivers. To some extent I will try and go beyond the QE simplification, but to a large degree I will wind up back there.
At the risk of sounding like a simpleton, I will start with the premise that a stock is merely a series of cash flows that the equity holder is entitled to.
There are 3 basic ways that the value can increase. We can see higher current cash flows, expectations of future cash flows could increase, or someone is willing to pay more for the same stream of cash flows (or some combination of all 3).
The most basic “QE” argument is that money is created by the Fed, comes into the system and finds its way into stocks. This would be predominantly a “willing to pay more” argument. Nothing else has changed but there is more money chasing the same flows, so the price goes up. This is the least compelling argument to me and the most likely to have front run itself out of existence.
You could get real global growth. Real demand increases across the globe and see real growth. That would be great and be the best driver for stock valuations.
On the other hand you might see further QE related growth. Individuals borrow money and spur growth – most likely in housing. This is good but may rely heavily on government subsidized mortgage rates. Would it be sustainable if the Fed pulls back?
There has also been the “financial engineering” growth. Apple using bonds to buy back stocks shifts around the cash flows in a way that is favorable to the equity market. That is good, but is also heavily dependent on QE. If QE is pulled back and bond yields start to move higher (big ifs) how sustainable is the pace of pillaging the balance sheet in favor of equity holders versus creditors?
So I think equity markets have benefitted more from QE than the bond market itself.
The Real Scenarios
Let’s now look back at our 4 scenarios and try and place some drivers that would force the market into that quadrant.
To get to NIRVANA you need real global growth. That is key for driving stocks higher. To see treasuries do well, you would need to see the Fed continue to be highly accommodative. QE would still be there, fueling stocks and bonds. You would need to see inflation remain calm. This has been the state we have been in for much of the period of February until early May.
The GREAT ROTATION is where we currently seem to be, but I don’t see many of the conditions having been met. Yes we have some degree of growth, but I don’t see any signs of rate hikes, QE remains in place, and inflation is low. We need to see growth that sparks inflation to remain in this state, and we are not seeing it. Even then we would need the Fed to respond to it by raising rates. It is also unclear to me how junk bonds would react, but I suspect negatively which would make it difficult for this state to be self-sustaining for a long period of time. Mortgage rates are also rising under this scenario, hurting housing, making it again difficult to maintain as a state.
The RISK-OFF trade is tricky because it seems so impossible after the past few months, but from a realistic standpoint, it seems plausible. We aren’t seeing great global growth and even domestically the data isn’t that strong. ZIRP is entrenched and we are not seeing many inflationary pressures. QE is under some pressure as some members appear to be concerned that QE is distorting the economy (I take it as a matter of faith when a Fed member says they don’t see distortions that it means they do – Plosser). Mortgage purchases also seem to raise more issues for Fed members, but without mortgage support where is housing?
The MESSY state seems to be the least likely. Unless something really bad happens that causes either inflation to spike or US Credit Risk to spike (neither of which seem particularly likely) then I think it is hard to see both markets move lower. I think they could start moving lower together, but then we would see a return to flight to safety. So while possible, I don’t think it is sustainable for small moves, and I don’t think the real “cataclysmic” state where we see steep declines in both is at all likely.
So we see scenarios with increasing treasury prices as the most likely, and weakness in stocks a little more likely than further strength based on the factors that we think drive the potential scenarios.
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