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“What’s the bond market telling us?”

“What’s the bond market telling us?”

This seems to be a very common question these days.  As yields continue to fall and stocks continue to rise many people assume that there’s some necessary disconnect in the way bond markets and equity markets are reacting.  So you often see people asking a variation of this question which is “does the bond market know something that the stock market doesn’t?”   I don’t think this implicit correlation is a very good way of viewing things.  And here’s why.

Bond traders primarily care about the return OF their capital and the real return ON their capital.  When we talk about the US government bond market the return OF capital is pretty certain.  If you buy a 10 year US government bond there’s only a small chance that the US government won’t pay you 100 cents on the dollar in 10 years.  After all, this is an entity with hundreds of trillions of dollars in assets and the ability to tax 23% of world output.  In addition, the people who worry about the US government “running out of money” tend to misrepresent the situation (see here for more on this).  So bond investors in the USA mostly care about the real return on their capital.  So, when inflation is low bond traders are happy to take a bit lower yield in return for owning something that’s essentially risk free.

This gets tricky when we assume some economic or stock market correlation because of all the moving parts.  In general, the assumption is that lower yields are a sign that inflation expectations are low which means expectations of future growth are low which means that the stock market will go down, etc.   But this assumes three things which I don’t think are necessarily true:

  1. it assumes that the economy can’t grow during a period of low inflation;

  2. it assumes that the stock market is directly correlated to the economy;

  3. it assumes that bond traders are more prescient than stock market traders.

But none of these assumptions are necessarily true.  We know that inflation expectations can drop for decades during a relatively healthy period of growth.  That’s been the experience in the USA for the last 30 years.  And we also know that the stock market does not perfectly correlate with the economy and in fact, the economic cycle tends to lag the market cycle.  And it would be somewhat presumptuous to assume that bond traders are necessarily smarter than equity market traders even though that’s a commonly held belief in Wall Street circles.

So, what is the bond market telling us?  The bond market is telling us that inflation is currently low.  But don’t assume that those bond traders are necessarily right about future inflation expectations or that they won’t overreact when the facts change.  And don’t assume that low inflation means no growth or negative growth.  And lastly, don’t assume that falling bond yields represent a bad environment for stocks.  So be careful listening to this narrative about bond yields which assumes falling yields portend big problems or some disconnect.  Thinking so narrowly can get you in trouble.

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