Tumbling yields diverge from stocks

As US bond yields extend their selloff to 6-month lows amid concern of anaemic growth at the same time that stocks hit record highs, questions about the sustainability of the yield curve and its medium term implications for the global economy are raised.

No ‘operation twist’ this time

As the chart shows, the last time stocks were at this level relative to yields during a rising trajectory was in summer 2013. But the last time stocks had been at these levels relative to yields during a rising trajectory was in spring-summer 2012– when the Fed was halfway into its operation twist program of selling short-term bonds (less than 3 years) and buying longer term ones (6-30 years).

Operation twist had been aimed at reducing longer term bond yields relative to short-term bonds in order to boost the mortgage market and encourage investors into stocks, away from low yielding bonds.

Eventually, the Fed’s operation twist slashed long term yields in half, dragging the 10-year yield to a record low of 1.37% in July 2012. This helped equities find a bottom that summer and add another 35% to most indices. As the chart shows, the S&P500/10-year yield ratio soared to new record highs, intensifying the run of cheap money in stocks.

Today, the US bond market is hitting new highs as yields drop on a combination of dovish reminders from Fed Chairwoman Yellen about the labour market needing more participation.  As China’s weakness broadens, US will import lower prices, giving the Fed no choice but to further delay any assessment of higher interest rates.

As the US economic data begin showing a gradual improvement post-polar vortex, equities will likely hold way, while yields may attempt a modest bounce. Fed speakers will likely begin issuing less dovish remarks in order to support falling yields. If the message doesn’t get through, then 10-year yields will likely hit 2.38-39% (200-WMA) and there goes the much-fabled rotation from bonds to stocks.

Such a scenario is likely to be accompanied with further dollar selling and escalating interest in emerging market assets for their higher yields.  A reversal of the current trend could emerge from hawkish Fedspeak and/or new barrage of robust US data.

Mind the flattening curve

Although most bond strategists had been calling for 3.0% on 10-year yields back in January, there is a deafening silence and hesitancy among credit market experts to call for a decline back to 2.0%. Not only that would indicate another botched forecast at higher rates, but would imply a possible economic contraction in the US and/or re-emergence of new fears (possibly from Ukraine, Eurozone debt or Syria).

If these dynamics re-merge, traders will need to look watch the overall shape of the US yield curve, for any curve flattening will escalate fears of another recession and the next real market crash. The good news is that we are at least 6-9 months away from such day of reckoning, and any 5-7% selloffs in equities aren’t likely to extend beyond that for now.