I am relieved to report that my world has, at least for now, returned to the natural order. The last few years have been completely disorienting for those of us trained in the ways of the market decades ago. In the uncertain world of a trader there are very few predictable things to which one can cling, but the behavior of U.S. Treasuries in relation to stocks and in reaction to news was one of them. It was simple; if stocks went down or if there were bad economic news, Treasuries went up. This makes sense. Money, like nature, abhors a vacuum... it has to go somewhere. U.S. Treasuries, as the "risk-free" asset, had a unique role as the "Free Parking" space on the financial Monopoly board; it was where money went when not deployed elsewhere.
As a young man in a trading room, I was taught to think of the Treasury market as the starting point for all things financial. Most individual investors think of the stock market first. They think that in times of trouble money is pulled out of that market and put in bonds. We were taught to think of it the other way around. The U.S. Treasury market was the natural home for global cash. When things looked good for certain assets money would be sent away to work in those markets, but at the first sign of trouble it would run back home to the safety and security of Treasuries.
This explained the underlying thirty year bull market in bonds, even as the value of equity markets increased around the world. The global economy was growing, and that was a lot of extra cash chasing paper... everything had to go up in price. The problem for Treasuries, unlike stocks, was that the move up in price was, by definition, finite. As the price of a bond goes up, so the yield goes down and while some Central Banks may flirt with the idea of negative yields at times of trouble, zero provides a floor for yields and therefore a ceiling for price.
Following the credit crisis in 2008, the Fed took measures to force us close to that floor. They effectively cut near term rates to zero then embarked on a massive bond buying program (QE) that pushed the whole yield curve lower. At the time, I have no doubt that this policy was fully justified, but history's verdict on Bernanke et al will be determined by the exit from, rather than the entry into, QE. If this can be achieved in an orderly fashion while avoiding too much underlying inflationary pressure, then the retiring Fed Chairman could well be looked at as the savior of financial markets; if not he will be accused of creating the bubble of all bubbles.
Whatever the verdict of historians, however, the short-term market distortions have been huge. That natural inverse relationship between stocks and Treasuries has been destroyed. Anything that might have been seen as precipitating an end to QE caused rumblings in both stock and bond markets simultaneously. This chart, showing the relative performance of the S&P 500 and the iShares 10-20 Year Treasury ETF (TLH) over the last 6 months, shows the problem.
Prior to November of last year, stocks and bonds spent a lot of time moving in concert. Even as they began to diverge, it was more to do with the fact that the stock market was exaggerating and sustaining gains than anything else. Then, yesterday, there were signs that some degree of order was returning.
As stocks traded lower yesterday, Treasuries actually gained in value (see the small tails converging at the end of the above chart.) Ah, the sweet look of normality... The problem is that this can't go on for long. The underlying situation hasn’t changed. The Fed is exiting its bond buying program, albeit very slowly, and interest rates will be normalized over the coming years. I have said many times that I am not in the rapidly rising rates and roaring inflation crowd of scaremongers but the upward trajectory of rates, and therefore the downward trajectory of Treasury prices, looks pre-determined.
Given this, and given that those that control the big money are aware of it, there will undoubtedly be a lot of money seeking a home as that dynamic unwinds. A 3% yield on a 10 Year Note isn't that appealing, even in times of worry, if capital losses over the long term have an inevitable feel to them.
Remember, money abhors a vacuum, so stocks are still set to benefit.
Whether you are looking at the big gains over the last few years or earnings multiples edging up over the historical average, and are worried about the stock market, I would say to temper your concerns. As those concerns intensify for some there is likely to be some volatility, particularly in the early part of the year, but keep an eye on Treasury yields. The more they react in a normal fashion to a falling market and fall with it, the more likely it is that the drop will be limited. With the big picture in mind, rates can only go so low and eventually the money sent home for a rest will be sent back out to work, and stocks will arrest their decline.
Staying in the stock market for those already invested and buying any dips for those with cash is the obvious conclusion for investors. Don't let yesterday's appearance of normalcy fool you; this Treasury market is still distorted. While that situation unwinds stocks will receive support by default to limit the effects of any bad news and, if things look good, then any upward move will be exaggerated. The topsy-turvy world of yields and stocks increasing in tandem has not ended, just paused. This is bad news for my sense of what is right and normal, but potentially good news for equity investors.