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A Growing Disconnect

I am intrigued, and perhaps concerned, by the growing disconnect between stocks and bonds. The 10y yield fell to 2.91%, only three basis points above its low yield of the year, and the September Note futures contract went to a new high. Contributing to the fixed-income rally was news that GM’s sales in July rose 1.5% and Ford’s fell 0.7%, when analysts were expecting 10% gains (It appears that perhaps GM didn’t need to stay open during the usual retooling period after all!), flat Personal Income and Spending data (near expectations, however), and a drop in Pending Home Sales when analysts had been looking for a gain. Late in the day, the ABC Consumer Confidence number matched the lowest print of the year at -50, only a little above the swoon lows of -54 in December 2008.

So bonds seem to be pricing anemic growth both currently and in the near future. And it is a growth story, for while TIPS yields are now negative out to the 5 year point, the inflation curve is rising and flattening. The chart below (Source: Bloomberg) shows 2-year inflation swap rates are at the highs for the last couple of months, which is certainly curious given all the talk of imminent deflation.

Rates aren't falling because of inflation expectations.

Indeed, I expect that real yields might go negative even further out the curve. At these yields, to be sure, TIPS become less competitive with real assets that have zero real return, such as residential real estate and gold. But do you remember how I pointed out that Gross, by declaring prices had outright fallen for two years, was pretending to be unaware that the effect came almost entirely from oil? Crude had fallen from 145.29 in July 2008 to 33.87 in December 2008, and we felt those repercussions in the price index for much of 2009. But now, oil is back above $82 and has risen $10 in the last month.

The dollar, whose strength in late 2008 helped fuel the deflationary pulse, replicated that feat in the first half of this year when the dollar index rose some 20%, from 74 to 89. It is back to 80 (see Chart, Source Bloomberg). The whiff of deflation you think you smell? Better sniff quickly, because it’s going fast.

Dollar strength is turning into weakness, just as people get worried about falling prices.

We can go deeper than these markets, though. The chart below (Source: Board of Governors, adjusted by me) shows commercial bank credit growth. I first started running this chart in 2008, when the growth rate of credit turned negative year/year for the first time since data begins in 1973. (As an aside: I adjusted for the fact that Goldman and Morgan Stanley abruptly became commercial banks during the crisis, causing a huge spike in commercial bank credit merely because the credit was re-classed and keeping the official rate of credit growth positive for a year).

Bank credit may soon stop contracting so vigorously!

This has been a nothing-new-to-see-here chart, with the same bad news, for the last few years. But it is starting to look as if commercial bank credit may be turning the corner and … well, anyway, it may stop contracting, and that’s the first step toward stable or higher money velocity.

These things are all happening while, and perhaps because, the “Fed Mulls Symbolic Shift” according to the Wall Street Journal. The symbolic shift in question is to take the cash flows from its rather ample bond portfolio – the coupons and maturity flows – and use it to buy more bonds. The Fed otherwise would be letting its portfolio shrink slowly, something that the guy in charge of the System Open Market Account (SOMA), Brian Sack, thought wasn’t any big deal. Dr. Sack said back in March that even if the Fed were to actively sell the securities in SOMA, rather than just let the mature, it would have little effect on market rates if it were done slowly. (I was skeptical: see my analysis here).

Apparently, either the FOMC isn’t so sure of that, or they feel they can’t take even a small chance that it does. Moreover, as I have suggested recently, if they are actually moving toward buying more securities it would seem a good first step would be to start reinvesting the existing cash flows as they arrive.

Stocks did decline today, but only 0.5%. Either the equity market isn’t reading the same thing that the bond market is, or there are people investing in stocks because they believe equities have inflation-hedging attributes. In the long term, they may, but as the chart below illustrates (Source: Robert Shiller, data from Irrational Exuberance available at http://www.econ.yale.edu/~shiller/data/ie_data.xls) the move from low inflation to either inflation or deflation is a negative valuation shock.

More inflation means lower valuations.

Inflation right now is just about in the sweet spot for valuations. If inflation were to go to, say, 8%, then the 17-18x earnings multiple we expect would go to a 10-12x multiple. That 37% decline in valuation will overwhelm any inflation-hedging properties of stocks for a while.

Moreover, I would be willing to guess that inflation in the context of strong growth is what equity owners are hoping for. The negative yield of TIPS suggests that, rather, what may be on offer is inflation in the context of weak growth. I shouldn’t harangue the equity guys. The low volumes suggest that the current rally isn’t exactly a stampede, although it could become one at any time I suppose. But in general, given a chance to bet with the bond people or to bet with the stock people, I generally go with the bond people. I would go with the TIPS people, but there still aren’t enough of us.


Wednesday’s data includes the ADP cut at the jobs data (Consensus: 30k) and the ISM Non-Manufacturing Report (Consensus: 53.0 from 53.8). I suspect the former is more important.

A reminder: my book is still on sale via this link! Incidentally, I have been advised that I have chosen boring quotes from the book for that teaser page…I will find something more interesting to say there, but for now just ignore them – the book is better!

Categories: Uncategorized
  1. Andy
    August 4, 2010 at 12:08 pm

    Here’s a thought. we are witnessing a bond market ‘bubble’. that’s why bonds continnue to rally in the face of other less convincing reasons. think of it, investors have a small amount of confidence, and are not fleeing equities, nor emerging markets, but are not really rushing in there either. perhaps they look around and see significant invetable cash and need a place to put it. perhaps they think, ‘ah, the Fed is going to buy more bonds, and banks are still unwilling to lend money to people, but are happy to buy treasuries’ and perhaps they think that even though values don’t make that much sense, “This Time Is Different!!!” and bond values are really set to increase in a deflationary world. buying bonds for the wrong reasons at bad valuations, sounds an awful lot like tech stocks and houses, no?

  2. August 4, 2010 at 12:40 pm

    Yeah…”I don’t have much upside, but on the other hand with the Fed buying I don’t have much downside either!” Good point.

  3. Fullcarry
    August 5, 2010 at 7:46 am

    If inflation went to 8% bonds would sell off also. Equities are cheap relative to bonds. Compare earnings yield vs 10 year yield. Leveraged trade is to buy diversified dividend paying equities and hedging with USTs.

    • August 5, 2010 at 8:57 am

      Earnings yield is a fairly useless measure in my view, since earnings can be easily manipulated and most measures that are reported these days for the indices exclude negative earnings (so the actual earnings yield is exaggerated). The dividend yield of the S&P is 2% versus 10y Treasuries at 3%. Treasuries may be rich, but stocks are certainly not cheap! Remember, if Treasuries go to 8%, the dividend yield should also go up. That can happen one of two ways: (1) companies decide to pay a lot more out in dividends, even though dividends are about to be tax-disadvantaged compared to how they are currently treated, or (2) stock prices fall, causing the yield to rise. (That same analysis works on earnings yield, but I just think earnings yield is not a useful analytical measure).

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