In memory of Dr. Andreas Höfert

The bond market is always right – right?

| Tags: Andreas Höfert

Government bond markets have stayed surprisingly pessimistic during the dramatic equity market rally going on since the beginning of the year. US Treasury yields have finally started to come around in the last few days, but this doesn’t necessarily indicate improving economic fundamentals.

Many investors are coming to regret staying on the sidelines during the recent equity rally. However, except for rising prices, there were few compelling arguments to persuade more cautious investors to enter the market. Three features in particular looked suspicious.

Firstly, transaction volumes stayed fairly flat despite rising equity prices, and have only now really started to pick up. Furthermore, they were stuck at a very low level – roughly 25% below the two-year average for the S&P 500. Not a very bullish signal, as most technical analysts would be quick to point out.

Secondly, in the first two months of the year, all asset classes were correlated to the point of moving in sync. Stocks rallied, sure, but so did bonds, gold, oil, and many other investment vehicles – you would have a tough time finding an unhappy investor this year. When all assets move like that, it’s usually because of fresh liquidity hitting the markets. The European Central Bank’s Long Term Refinancing Operations injected more than one trillion euros, Quantitative Easing 3 from the Bank of England weighed in at 50 billion pounds, and now even the Bank of Japan is using “unconventional measures.” These waves of liquidity have undoubtedly helped to buoy asset classes across the board.

Most importantly, yields on US Treasuries were quite low until about two weeks ago – indicating that bond market participants were not buying into the euphoria. Quite the opposite, in fact: Interest rates of below 2% on 10-year Treasuries usually suggest expectations of a weak or even recessionary economy. Interest rates have suddenly started to increase now, with 10-year Treasury yields rising by almost 0.4% to a level last seen in October 2011.

The government bond market may have a negative bias, but it usually provides a better indication of the state of the economy than the equity market does. Does this abrupt interest rate rise show that the bond market was too bearish this time, and that the equity market finally got it right for once?

This is certainly one possible interpretation. It would be good news, of course, if higher interest on government bonds reflected the US finally returning to normal. However, other plausible explanations are far less rosy. The first is that the myth of zero inflation is coming under increasing scrutiny, as even US core inflation has surprised to the upside lately – along with high oil prices that stubbornly refuse to come down.

Another possibility is that markets do not expect the US to tackle its public debt. President Obama recently extended the payroll tax cut for another year, a program worth almost 150 billion dollars, and 2012 looks to be yet another wasted year as the presidential elections approach. Meanwhile, China and Japan both face shrinking trade surpluses, which means they are less willing – or even able – to finance the US at such low yields.

The bond market may indeed be right to push interest higher, but it may also be doing so for the right reasons, and not the reasons that equity market participants would like to believe.