Some of the most exciting action of the past few days hasn’t been in the stock market — it’s been in the bond market. Specifically, all eyes have been on the normally lackluster world of U.S. Treasury bonds where prices have soared. As a result, the yield on 10-year Treasuries has plunged to levels not seen since stocks found a bottom back in March 2009.
Normally, Treasuries are bid higher when risk aversion is increasing — but that doesn’t seem to be the case now. The smallest, riskiest stocks have been outperforming the broad equity market over the last five days. Fear, as represented by the CBOE Volatility Index (VIX), continues to fall. And industrial metals like copper, tin, and nickel are moving higher — which suggests metal traders are optimistic about the future of the economy.
Instead, it looks like today’s bond market action is a function of pure speculation. And speculation, a sign of animal spirits and easy money, is a positive sign of confidence. Compare this to capital preservation, which was the dominant mode of operation between 2007 and 2009. Eventually, all the money being pumped into the economy by the Federal Reserve and being funneled into the bond market will find its way into stocks.
Investors, who don’t believe lending money to the government for 10 years at 2.58% is a good idea, will look to equities for better returns. This explains the impressive performance of high yield stocks in the utilities, energy pipeline, and real estate sectors. Or corporate executives, with their coffers full of cash and enjoying access to ultra-cheap credit, will return wealth to shareholders via dividend increases, M&A activity, or share buybacks.
Either way, the so-called “bond bubble” won’t last forever.
In fact, there is a striking similarity between what is unfolding in the bond market and the 1990’s tech stock bubble. Statistically, there is a strong connection between the S&P 500’s performance between 1990 and 2005 and that of Treasuries over the last 10 years. The coefficient of determination, for you statistics fans, is a whopping 87% according to Citigroup research. The maximum value is 100%. The higher the number, the more closely the two data sets move in lockstep.
In the words of Citigroup strategist Tobias Levkovich, “The similarities should cause anxiety especially when one considers the high correlation and what it suggests about plausible future trends for bonds.” But these are worries for another day. Right now, the Federal Reserve is purposefully engineering the current rally in bonds — to lower mortgage rates and funnel cheap credit to consumers, banks, and businesses.
What the consequences will be, and whether this strategy of unprecedented monetary policy support will even work, are questions that will be answered in the months and years to come.
Be sure to check out Anthony’s new advisory service, the Edge, which is launching in September. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.
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