Michael Mackenzie takes a look at how bond yields have impacted the stock market over the past six months and how they have helped account for the continued growth of stock prices.
Six months ago, at the close, the S&P 500 stock index was at 3,337 and the Nasdaq was at 9,575. Both indexes achieved a near-term trough on March 23, with the S&P 500 closing at 2,237 and the Nasdaq closing at 6,860.
Of course, at the close this Friday, both were standing at new historical highs of 3,397 for the S&P 500 index and 11,312 for the Nasdaq.
Mr. Mackenzie writes:
The S&P’s taste of rarefied air this week, with Apple claiming a $2.0 trillion market capitalization, illustrates that size certainly matters. But investors should not ignore the supportive role played by suppressed government bond yields, and how they will shape the performance of equity and credit from here.”
The concern is that the new highs are a sign of market speculation, possibly an asset bubble, for there is no real support in the strength of the economy, nor is there any sign that the coronavirus pandemic will go away.
The New Economy
There is, of course, the argument that the US is moving into a new era, much more associated with a new economic structure based more upon technology – both information technology and the technology related to the health care industries.
Companies in these areas have benefitted from both the spread of the pandemic and the weakness of the current economy as forces have accelerated the movement toward the transition into the new structure. And given the weights that are assigned to these companies in both indices, it is understandable that investors are anticipating the future and building this future into stock prices… and, hence, the stock indices.
This change in structure is real and will not go away. So, this rationale for some higher prices stands. But Mr. Mackenzie does not believe that this is the whole story. In fact, he believes that much of the story lies elsewhere.
The Long-Term Bond Market
On February 13, the yield on the 10-year US Treasury note was 1.61 percent. By March 23, this yield had dropped to about 75 basis points! And at the close of business on Friday, August 21, the yield was around 65 basis points, representing almost a 1.00 percent drop in the 10-year yield.
How do these dates match up with anything else going on in the economy?
In my analysis of the balance sheet of the Federal Reserve, it appears as if the date of Wednesday, February 26, 2020 marks the time that everything began to change. That is, the Federal Reserve really began to change the way it was doing things so as to combat a looming liquidity crisis and also prevent the economic recession, which has been defined to begin in February, from getting worse.
In the next week or two, the Federal Reserve established credit swap lines with major central banks around the world, and the amount of swaps on the Fed’s balance sheet went from $45 million on March 18 to $206 billion (yes, billion) on March 25.
This is important, I believe, because of the fact that Germany, France, Japan, and Switzerland all had negative long-term interest rates at that time. Global investors could get US dollars, and plenty of them, through the European Central Bank, the Swiss National Bank, and the Bank of Japan and trade from negative yields to positive yields in the United States.
Global investors took this move as a sign of the real weakness in the US economy. I say this because the inflationary expectations built into the nominal yield on the US Treasury note dropped from right around 1.7 percent in the middle of February to around 1.0 percent on March 25. This drop was a shocker!
So, almost the total drop in the yield on the 10-year US Treasury note came from the drop in inflationary expectations built into the yield and as a part of the massive injection of funds into the world’s financial markets. Mr. Mackenzie believes that this drop in bond yields was the mechanism by which US stock prices recovered from the decline that took place earlier.
The yield on the 10-year Treasury note has remained low, but there has been a change in inflationary expectations. Inflationary expectations have recovered to now rest between 1.6 percent and 1.7 percent.
What has changed is the yield on the 10-year Treasury Inflation Protected securities (TIPs). As of the close on Friday, the 10-year yield on TIPs was at a negative 1.00, down from a negative 0.2 percent on March 25. This, to me, reflects the belief that the US economy is not growing very rapidly and is not going to return to more normal levels (2.0 percent?) very quickly.
But the lower yield on the bonds is having an impact on stock prices, helping them to achieve new historic highs. In this sense, Mr. Mackenzie is correct.
It Is Still The Fed’s Work
But to me, this is all still a part of the Fed’s work. In more normal times, Federal Reserve actions do not tend to have a great deal of influence on the yields of longer-term bonds. In the current situation, with world longer-term interest rates so low, the Fed is “owning” the financial markets.
The fact that inflationary expectations have risen is good for stocks. This is something that Federal Reserve officials have been shooting for. So, investors should be happy, which means stock prices should remain at current levels or even rise further.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.