Barron’s – 03/12/09 – While rising equity prices are suggesting a rosy outlook for the economy, rising short-term bond prices are suggesting concerns about what lies ahead.
OVER THE PAST DECADE, stock and bond prices have generally moved in opposite directions, meaning that share prices and bond yields have moved together, both higher and lower. Both share prices and yields set major bottoms in mid-2003 and major tops in mid-2007, give or take a few months. And while most major stock indexes bottomed again in March 2009, the bigger stocks on the Nasdaq bottomed in November 2008 — with bond yields. This important relationship held true this year until June, when bond yields peaked. One month later, as yields moved lower, stocks began their current leg up.
John Kosar, director of research at AsburyResearch.com, said that the 70% rally in the stock market since March tells us that stocks think the economy looks promising. However, the decline in bond yields since the summer tells us that bonds do not agree. (Bond yields fall as the bonds prices rise; investors tend to push up bonds prices when they sense trouble ahead for the economy and stock market.). Given their relationship at major turning points over the years, something is not quite right. And when it comes to trusting bonds or stocks for the correct « opinion, » history would suggest that it’s usually better to go with bonds. While economic prognostication is not my mission here, the divergence between stock prices and bond yields points to an eventual correction between the two. Something has got to give and again, bonds seem to have the better track record.
Clearly, this is not a timing model. However, it is a warning that the stock market is indeed being pushed by the outside force of high levels of liquidity. The problem is that when the liquidity dries up, as it must eventually, things could get dicey for investors. One part of the bond market caught my eye this week. The yield on two-year Treasury notes fell nearly 40% to an unreal low of 0.67% and is just a hair from its generational low of one year ago.
This is important for two reasons. The first is that one year ago, the financial markets were nearly frozen and investors looked for the safest places possible to park their money. Treasury securities with short maturities were the only assets that were holding their value and demand to own them pushed prices up and yields way down.
The second reason is that the yield on the two-year note joined three-month bills in approaching zero again. Longer dated Treasury yields, from five years to 30 years, are not even close to reaching respective 2008 lows and that suggests that some money is moving towards an extreme safety position again.
Last year, during the height of the crisis, investors keyed in on the TED spread, which is one way investors measure risk in the market. Originally named for its components, Treasuries minus Eurodollars, it has changed over the years to use Libor (London interbank offered rate). However, the concept remains the same. When the difference between the yields of risky assets, measured by Libor, and secured assets, measured by government guaranteed Treasury bills, widens investors perceive risk in the market. While the TED spread has remained tame this year after spiking up in 2008, it has been edging slightly higher since September. Clearly, it is nowhere near a panic signal but it does add to the body of technical evidence that suggests that the stock market is flying without corroboration from the bond market. To be sure, longer-dated bonds do not show such a relationship. Purchases of junk bonds and high quality corporate bonds has been rather stable since May so we cannot say investors are shunning all forms of risk.
However, on the short-end of the maturity scale something is definitely changing. And it does cast doubts on the stock market’s staying power.