By Martin Tillier
Something’s wrong in my world.
I, like every trader and broker before me, was taught to watch the bond market at all times. Bonds, and in particular U.S. treasuries, drove everything, or so we were told. We were taught to be wary of any move not backed by the corresponding move in the bond market. In foreign exchange, losses were run longer and profits taken quicker if the bond market remained quiet. If bonds hadn’t led the move, it was seen as far more likely that the market would bounce back. Equities traders felt the same way, and U.S. treasury prices were prominent on screens around the globe. Every advisor would patiently explain to clients that diversification between stocks and bonds worked because of the inverse relationship between the two asset classes. There was logic, peace and order in the markets, and therefore the world. Since 2010, however, chaos has reigned.
For the sake of simplicity, let’s look at 7-10 year Treasury prices* (as represented by the iShares Barclays 7-10 year Treasury bond fund (IEF) and the S&P 500 (SPX). When the world is right, these two indicators move in opposite directions; bond prices go up as stock prices go down.
The VectorVest charts above illustrate this relationship. Bond prices reached their low on August 2nd 2007 and the S&P’s high was on October 11th. This means traders had around two months to realize that the bond market had turned and position themselves for the expected fall in the stock market, which duly came about. Some chose to believe that things had changed and that stocks would keep going up. They were wrong and the old adage held true. Bond prices peaked at the end of 2008 and sure enough, around 2 months later, at the beginning of March 2009, the stock market bottomed. The point here is not that stock market moves are signaled by bond moves 2 months earlier. If it were that easy, we’d all be rich by now. Rather that the inverse relationship was still intact at that point. It all fell apart around the middle of 2010.
Since then the stock and bond markets have moved up in tandem. The last time the S&P was at today’s levels, IEF was trading below 90. Now it is around 20% higher. The previously reliable relationship appears to have broken down. It is generally suggested that there are two possible explanations.
- The stock market is wrong: For most investors this is the scary one. It could be argued that the only thing that has changed is the time lag. The bond market is still sending a message. The S&P shouldn’t be this high given Europe, slowing growth in emerging markets, and weak consumer confidence. The sustained support for bonds would indicate that the collapse, when it comes, will be swift and painful.
- The bond market is wrong: An easier pill to swallow for many. Despite all of the problems corporate profits are at record levels. Recent earnings misses are the result of high expectations and growth is still evident. The nervousness that leads to a flight from risk is misplaced. All is well in the best of all possible worlds.
There is however, a third option. It could be that this time things really have changed. There is a scenario in which both bonds and stocks can go up. If there is an increasing amount of money chasing a steady amount of paper (i.e. stocks and bonds) then the price of all of the paper is pushed up. This has happened as a result of quantitative easing. The charts above show the relationship changing around the 1st quarter of 2010, right at the time the Fed was winding down QE1. Well over $1 trillion had been injected into the economy. Housing was still struggling and banks were wary of making loans to businesses. The money had to go somewhere. QE2 had a more obvious effect on treasury prices as the Fed bought $600 billion of government paper directly. In short, the third explanation is that the treasury market has been distorted by the Fed’s actions and no longer tells us anything. The fact that stock and Treasury prices have moved up together for two years would lend credence to that view.
So, what is a poor confused trader to make of it all? I still believe that, intraday, one has to watch the Treasury market. On any given day, a move that is not mirrored by an inverse move in bonds is more likely to be short lived, and a significant shift in the bond market could well presage a move in the opposite direction for stocks. Over the longer term, however, things have changed. The fact that Treasuries are at record highs doesn’t mean that stocks are about to collapse. The conditions in the bond market have been distorted. IEF trading above 100 while the S&P500 flirts with 1400 is a fact, rather than impossibility. As unsettling as it is for old hands like myself, these modern times are different, and I have to learn to ignore the little voice in my head that says “disaster is just around the corner, I mean look at bonds!” My therapist and I are working on it.
*For the sake of simplicity, I refer to bond prices, rather than yields. If you are a bond trader, then you already think backwards and will have no problem reversing all arguments, scenarios etc. to fit your topsy-turvy world.
Martin Tillier has been dragged, kicking and screaming into the 21st century, and can now be followed on Twitter @MartinTillier.