Michael Mackenzie examines how bond yields have affected the stock market over the past six months and how they have helped reflect the continued growth in stock prices.
Six months ago, at the close, the S&P 500 stock index was at 3337 and the Nasdaq at 9575. Both indices hit a short-term low on March 23, with the S&P 500 closing at 2237 and the Nasdaq at 6,860.
Of course, at the close on Friday both were at new all-time highs of 3397 for the S&P 500 and 11,312 for the Nasdaq.
Mr. Mackenzie writes:
The S&P’s sparse air taste this week, with Apple claiming a market cap of $ 2 billion, illustrates that size certainly matters. But investors shouldn’t ignore the supporting role that declining government bond yields play and how they will shape equity and credit performance from here. “
The problem is, the new highs are a sign of market speculation, perhaps an asset bubble, as there is no real support for the strength of the economy, nor any sign that the pandemic is. coronavirus will disappear.
The new economy
There is, of course, the argument that the United States is entering a new era, much more associated with a new economic structure based more on technology – both information technology and technology related to people. health industries.
Businesses in these regions have benefited from both the spread of the pandemic and the weakness of the current economy, as forces accelerated the move towards the transition to the new structure. And given the weightings given to these companies in both indices, it’s understandable that investors anticipate the future and build that future into stock prices … and, therefore, stock indices.
This change in structure is real and will not go away. So this justification of some higher prices is valid. But Mr. Mackenzie doesn’t believe that’s the whole story. In fact, he thinks much of the story lies elsewhere.
The long-term bond market
On February 13, the yield on the 10-year US Treasury bill was 1.61%. By March 23, this yield had fallen to around 75 basis points! And at the close of business on Friday, August 21, the yield was around 65 basis points, which is an almost 1.00% drop in the 10-year yield.
How do these dates match up with everything going on in the economy?
In my analysis of the Federal Reserve’s balance sheet, it seems the date Wednesday, February 26, 2020, marks the moment when everything started to change. In other words, the Federal Reserve has really started to change its way of doing things in order to combat an impending liquidity crunch and also to prevent the economic recession, which was set to begin in February, from getting worse.
Over the next week or two, the Federal Reserve established swap lines of credit with major central banks around the world, and the amount of swaps on the Fed’s balance sheet rose from $ 45 million on March 18 to $ 206 billion (yes, billion) on March 25. .
That’s important, I think, because Germany, France, Japan, and Switzerland all had negative long-term interest rates at the time. Global investors could get US dollars, and lots of them, through the European Central Bank, Swiss National Bank, and Bank of Japan and go from negative to positive returns in the US .
Global investors took this move as a sign of the real weakness of the US economy. I say this because the inflation expectations embedded in the nominal yield on US Treasuries fell from 1.7% in mid-February to around 1.0% on March 25. This drop was a shock!
Thus, almost the total decline in the yield on the 10-year US Treasury bill is due to the fall in inflation expectations embedded in the yield and as part of the massive injection of funds into global financial markets. Mr. Mackenzie believes that this decline in bond yields was the mechanism by which US stock prices recovered from the decline that occurred earlier.
The yield on the 10-year Treasury bill remained low, but inflation expectations changed. Inflationary expectations have recovered to now rest between 1.6% and 1.7%.
What has changed is the yield on 10-year Inflation-Protected Treasury Securities (TIPs). At the close on Friday, the 10-year TIP yield was negative 1.00, down from 0.2% on March 25. This, to me, reflects the belief that the US economy is not growing very quickly and is not going to return to more normal levels (2.0 percent?) Very quickly.
But falling bond yields are having an impact on stock prices, helping them to reach new all-time highs. In that sense, Mr. Mackenzie is right.
It’s still the Fed’s job
But to me, it’s still part of the Fed’s job. In more normal times, Federal Reserve stocks generally do not have much influence over long-term bond yields. In the current situation, with long-term global interest rates so low, the Fed “owns” the financial markets.
The fact that inflation expectations have risen is good for stocks. This is something that Federal Reserve officials yearn for. Investors should therefore be happy, which means that stock prices should stay at current levels or even rise further.
Disclosure: I / we have no positions in the mentioned stocks, and I do not intend to initiate any positions within the next 72 hours. I wrote this article myself and it expresses my own opinions. I am not receiving any compensation for this (other than from Seeking Alpha). I have no business relationship with a company whose stock is mentioned in this article.
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