On bond and equity markets

kosh

Bad news bulls

Aug 10th 2010, 10:07 by Buttonwood

THERE are times when the equity and bond markets can both do well at the same time, for example when inflation is falling from a very high level or when a country is recovering from some kind of natural or political disaster. With inflation already low, this would not appear to be one of those times.

But as the chart shows, the stockmarket has rallied strongly in recent weeks while bond yields have fallen (yields are a better way of illustrating the issue than bond prices). A fall in bond yields suggests either that investors are becoming more risk-averse or that they fear a double-dip recession and/or deflation. A rise in equity markets suggests they are worried about neither.

So what is going on? This reminds me a bit of the late 1990s when, as a tech sceptic, I wondered why the stockmarket kept surging to stratospheric valuations. Whatever the headlines the market went up. Good news on the economy meant profits would be strong while bad news meant that central banks would cut rates, and thus profits would eventually be strong. This rally is of course on a much smaller scale but I think Jim Reid of Deutsche Bank is right when he writes that:

    risky assets have traded over the last month in a manner that suggests that good US news indicates the economic recovery is intact and bad news is interpreted as increasing the probability of imminent QE. A kind of win, win for risk assets.

In short, the bulls hope the Fed is going to ride to the rescue and print more money. The Fed's statement turned out to be a compromise; it will keep its holdings of Treasuries constant by rolling them over as they mature.  But I also wonder at the serene faith of equity investors in the Fed's ability to revive the economy. A mountain of stimulus has produced a molehill of recovery. As the statement says

    Bank lending has continued to contract..,,,the pace of economic recovery is likely to be more modest in the near term than had been anticipated.

Given the lack of success so far in generating a V-shapred recovery, will maintaining QE really change the outlook? Surely if QE was going to work, bond investors should be a bit more nervous. Yes, in the short-term, the Fed is supporting Treasury bond prices. But in the long-term, all that debt will either have to be sold back into the market, (or stop rolling over the debt when it matures). The choice for the bond market is either a lot more debt, or a bigger money supply, neither of which would seem attractive.

So the bond market is surely betting that the Fed's actions won't work and that Japan is the template; the equity market is betting that the Fed will be successful and the Goldilocks economy will return.

kosh

Will Bond Or Equity Markets Crack First Under QEII?

By: Peter Cooper, Arabian Money


-- Posted Sunday, 17 October 2010 | Digg This ArticleDigg It! | Share this article | Source: GoldSeek.com

By printing money the US Federal Reserve is devaluing the US dollar and thereby the value of US bonds held by foreigners. If the dollar drops sharply in value as it has over the past few weeks, then the tiny interest payments on bonds make these far from safe assets. The bond holders are losing money.

Pimco, the largest US bond fund, says the bond rally is almost over. The Chinese have cut their US bond holdings by more than 10 per cent over the past year. Yet the buyer of last resort, the Fed itself has kept the bond market aloft. This will not work for much longer. Even old Alan Greenspan warned as much a week ago.

Tipping point

Soon the cost of servicing these debts is going to reach a tipping point. For beyond a certain point any debtor is in trouble as they have to borrow bigger and bigger amounts to pay their interest until the loan starts to mushroom in size.

At the same time the excess liquidity created by money printing or quantitative easing as it is called, is blowing up a bubble in global stock markets. Nothing in the global economic outlook justifies these price rises nor the low volumes of shares being traded.

The money just has to be a carry trade from cheap dollars being driven into stock markets more or less directly by the Fed. For if you inflate equity then you depress the debt burden. For debts, in theory, remain static in nominal terms while equity rises creating wealth.

That is the basic principle of house price inflation too, and we all know how that ended. The trouble is a little thing called fundamentals. House prices, for example, can only rise so far out of line with rentals. Share prices can only rise so far out of line with profits. But these things get forgotten when a bubble is blowing up.

QEII failure?

Perhaps the achilles heel is the QE process itself, and the ability of the Fed to hoodwink the markets. For money printing only works – and it is arguably not working because it is not delivering growth in the US – for a short period before it trips up over itself into a nasty inflationary mess.

Is that not now what we are starting to see with rising oil and commodity prices? Investors are selling the dollar and buying gold and silver. Share prices by comparison are more vulnerable because they are only paper representations of a company’s worth. Real assets have a more direct relationship to the volume of money in circulation than stocks.

Stocks will rise until there are no more buyers and then they have to find a new level. Might that not be when QEII is announced very early next month? A case of buy on the rumor, sell on the announcement? Certainly by then every buyer that can be pulled into the market will be there, leaving only one way to go and that is down.

Ironically that also answers the question about the bond market. For this stock market correction would give bonds a last spike higher, as some delusional fools would still see them as a safe haven. Others would use an accompanying correction in commodities to advantage as a buying opportunity and buy gold and silver.

coexist

"buy on the rumor, sell on the announcement"