What is the bond market telling us now? Maybe nothing at all
- “The key benchmark yield beat expectations… On Thursday, the 10-year yield was close to 1.25%, its lowest level since February. Even outside the confines of the bond market, this raises a question: what is wrong with this picture? ” – Barron, July 10, 2021
In recent years, and especially this year, a fascination has grown to interpret movements in the Treasury bill market as a sentiment indicator and forecasting tool, for everything from stock market outlook to recession probabilities or threats. inflation, and even changes in the Federal Monetary Reserve. Politics. Some people place great importance on small adjustments. They see Treasury yields as an ultra-sensitive diagnostic instrument, an EKG for the US economy. Or maybe a better metaphor would be a constantly flashing “hazard light”. Whatever the 10-year rate does – up or down – it’s always bad news.
The Sky Is Falling – Q1: The Inflation Panic
In the first quarter of 2021, bond yields rose, meaning prices fell and bonds fell in value. As described in a previous column, panics the commentator. “The first quarter was the darkest in the market for four decades. The bond market would have been pulled by a fear of impending inflation, “real kryptonite” for Treasurys. (This has been seriously discussed, even though inflation has been absent from the US economy for decades.)
(My analysis at the time it was the opposite. I said that the bond pullout had nothing to do with inflation expectations, but that it was a very positive development, driven by the reallocation of investors to stocks to embrace the prospect of a dynamic recovery after the vaccine announcements and the resolution of the US presidential election. uncertainty. Considering how things have evolved, this now seems obvious. So can I say? – I was right.)
The Sky Is Falling – Q2: “Slow Growing” Darkness
In the second quarter, the bond market reversed. Yields have plummeted. Which of course means that bond prices Pink. Obligations increases value. Up 3.5% in the last 90 days or so. Good enough for the “ultimate security asset”. Which means that a lot of people were purchase Treasury bonds. So what is the problem?
(It is always good to point out the inverse relationship between bond yields and bond prices. Financial Time got it wrong in Saturday’s main editorial, looking for a negative interpretation – “Yields fell as bonds sold” [sic])
The interpretation of this momentum? “Slower growth to come. “ Investors are supposed to buy Treasuries now out of sheer pessimism.
- “The strange behavior of bonds could portend a weaker economy in the second half of the year” – The title of Barron (July 10)
- “Fears about rising prices have given way to worries about economic growth ”- FT Title (July 10)
This austere vision apparently does not take into account the “overheated” economy, which is now expected to post growth of nearly 10% in Q2. He dismisses the lingering inflationary threat and growing indications that the Federal Reserve may be considering starting to “think about thinking about…” (shrink, tighten, twist, but only in brackets).
And yet, one way or another, “the bond market didn’t get the message” (again, from Barron) – and investors have gorged themselves madly on Treasuries in recent weeks.
The sky is falling – Q3: Bonds are crushing stocks?
If bond investors are so strangely stunned, perhaps the expected negativity has taken root in the stock market.
- “[Stock] Investors panicked. About what? It was hard to say, but it seemed to be pulled by the Treasury market, where the 10-year note tumbled… ”
The equities picture is really much simpler: The stock market has risen relentlessly throughout the “Great Bond Wobble of 2021”.
Signal is stuck on red – or is there really a signal here?
Whenever the bond market trembles, that is, whenever bond yields fluctuate slightly, up or down, it is always taken as bad news. Even when the change is small, it’s still bad news. In March, the the Wall Street newspaper sounded the inflationary alarm on yields rising by just 50 basis points. We have now returned much of that increase, and the alarm bells are still ringing.
In some situations, bonds reflect the macroeconomic outlook – although this is usually only when there is a clear crisis, when the tendency and motivation to move into safe-haven assets is so obvious that no confirmation is needed. (If the patient has passed out on the floor, you don’t need an ECG to tell you something is wrong.) When the Covid pandemic hit in March 2020, bond prices rose ( and yields have plummeted). It was a classic flight to safety – panic buying of Treasuries by investors looking to get out of the stock market crash.
But most of the time, movements in the bond market are ambiguous. In a truly excellent book – The dollar trap– Eswar Prasad describes this “mixed signals” problem. (These words were written 8 years ago, but they are easily applicable to the current situation.)
- “A complex balance of power is at play in the US Treasury debt market. Rising bond yields for the right reasons – a pickup in economic activity, a tighter job market, and modest increases in wage and price inflation expectations – wouldn’t be such a bad thing… On the other hand, an increase in bond yields due to growing concerns about the level of debt and a possible surge in inflation without a strong recovery would be bad… The problem is that these two outcomes are equivalent observation short term.”
A signal that cannot be interpreted is just noise. A signal that can freely accept contrary meanings is… meaningless.
For example, bond yields fell even more in the 12 months from Q3 2018 to Q3 2019 than they did during the pandemic – yet the economy in 2018/19 was exploding, with real growth. of 3%, a record unemployment rate and no inflation.
Bond yields are a very poor indicator of stock market conditions – outside of times of severe crisis. Treasury bill yields and equity returns were quite correlated (67%) in the 1st quarter of this year. But they were negatively correlated (negative 68%) in the 2nd quarter.
Bond yields don’t even predict inflation very well. Over the past 20 years, the yield on 10-year Treasury bonds has only shown a 25% correlation with the consumer price index (excluding food and energy). Given the nature of these two measures, one would expect a much stronger association.
Bond yields don’t matter in the short term
Placed in their context, that is to say over a longer historical period, these recent movements do not seem so important.
What stands out in the big picture is the enormous secular drop in the cost of US public debt. (Indeed, if we extend the timeline for another two decades to the 1980s and 1990s, the downward shift is all the more striking.) The implications of this long period signal are extremely important. Corresponding to similar trends in all developed debt markets (Europe, UK, Japan), falling interest rates represent a current saving of perhaps a trillion dollars per year in debt servicing costs. reduced debt for these governments, compared to just 20 years ago. This is enough to allow for major structural adjustments in government, to name just one aspect of the situation.
There are big wheels turning here. Prasad’s book examines, for example, the issue of central bank reserve accumulation, as well as the dollar’s role as a global reserve currency and the role of the Fed as a global central bank. His description of the mechanisms of reserve financing and the “sterilization” of trade surpluses is fascinating. Obviously, quantitative easing has also played a role since 2008. But in the short term, I doubt bond yield changes of a few dozen basis points one way or the other – unless there is a clear crisis. – have any importance as sentiment indicators. Maybe the short-term moves we see aren’t “weird” or “confusing” – because they don’t really “mean” anything. It might just be good old-fashioned supply and demand.