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In the last few days, several market participants and watchers have highlighted a decoupling of equity and fixed-income markets that has seen the Dow Jones and S&P indices soar impressively to record highs while yields on 10-year and 30-year US government bonds have remained relatively low. One respected observer noted that “bond investors do not believe the excitement over growth in the stock market”. Another, equally astute, commentator wrote that “bond investors are sending a very different view”.
This would not be the first time bond and stock markets have sent different messages; and it would be a bigger potential issue for stock than bond investors who operate more in macro space and can claim greater insights on economic prospects. Specifically, while the shorter-end of the yield curve for government bonds is anchored by central banks, the rest is much more susceptible to how market participants see the prospects for economic growth and inflation. The same goes for spreads on corporate bonds, though they are also affected by the prospects for corporate liability management and new issuance, including how this is distributed throughout the capital structure.
But before pressing hard on the stock/bond divergence alarm, investors should think about five issues associated with what has been happening in the trifecta of fixed income, equities and foreign exchange.
Not all segments of the bond markets are giving the same signal. While yields on 10-year and 30-year US Treasuries remain relatively low and fuel growth scepticism, corporate bond spreads have been sending an opposite signal — by compressing significantly, with the riskier credits in high yield and emerging markets outperforming. The same is true of non-agency mortgages where, again, a notable part of the expected return reflects expectations of better economic conditions.
Europe continues to influence longer-dated US Treasuries. With financial globalisation where capital flows across national borders looking for higher returns, US government bonds offer a yield pick-up on “risk-free” exposures. Continental rates are depressed by a more dovish European Central Bank and by the unusual degree of political risks associated with a heavy election calendar that cannot ignore anti-establishment movements (including France and the Netherlands). Indeed, you need only look at the persistence of negative yields on several German government bonds, the closest international substitute for Treasuries when it comes to credit quality in government bond markets.
Foreign exchange markets are less able to reconcile divergent interest rate prospects. In a world of policy and economic decoupling, exchange rates would adjust and act as a counterbalance to cross-border bond flows. But dollar appreciation may well have been tempered by the unconventional approach that the Trump administration has taken to currency commentary — one that has seen a change in both messaging, with a departure from the “strong dollar” mantra, and in messengers, with more officials commenting on a policy issue that has traditionally been reserved for the Treasury secretary.
Anticipated flows act as additional fuel for the equity rally. Anecdotal evidence suggests that stock investors are looking forward to a future involving bigger inflows into the marketplace. A large part would come from corporate cash currently held abroad that, following anticipated policy changes by the Trump administration as part of its planned tax reform initiative, would be repatriated and partially deployed for share buybacks, higher dividend payments and stepped-up M&A activity. A smaller part would come from underexposed investors putting more funds to work in the stock market.
Framing differences matter. Given the different risk/return construct of their markets, bond investors tend to place greater weight on downside risks compared with stock investors who are typically a more optimistic bunch. The impact of this and other behavioural considerations is greater in an uncertain world where President Donald Trump’s fiscal and deregulation measures face tricky design and implementation issues, there are competing signals on trade, congressional posturing is far from over and the US economy continues to face structural headwinds to higher and more inclusive growth.
The net impact of all this is not to doubt the validity of the view that bond and stock markets are on different wavelengths. Rather, it is to caution against making too much of the divergence at this stage, pending more detailed analysis.
Mohamed El-Erian is chief economic adviser to Allianz and author of ‘The Only Game in Town’