Stock markets are the Kardashians of the financial world. They’re sexy, dramatic, and not that complicated. Their motivations are simple, and they are driven by emotions, whims, and a long-term fascination with money.
But, like the Kardashians, stock markets don’t bear much of a relationship to the real world – or, at least, their relationship to reality is tenuous. If you’re looking for insight into what matters to the bricks-and-mortar world of ordinary mortals, the Kardashians (stock markets) have no wisdom for you.
Rather, you should look to bond markets. While stock markets are generally driven by sentiment about potential profitability and stocks’ relative attractiveness compared to other instruments, bond markets give hard insight into two key things: Long-term expectations for the value of money and long-term downside risks.
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Many people who buy stocks do so because they expect to be able to sell those stocks later to someone else. Stocks are an ownership stake. Bonds, on the other hand, are instruments that will be paid back. If you lend a company money, they either will or will not pay it back along with relevant interest payments. It’s a different bet.
In addition, sovereign bond markets include a lot of information about the broader economy. Buying a South African Government Bond (SAGB) is not a bet on any one company, it’s a bet on SA Inc. So, bond prices give a real sense of what investors think is coming down the pike.
Bond markets are, unfortunately, a bit harder to understand than stock markets. But it’s worth making the effort because you can learn a lot by looking at various bond markets. Let’s see what they’re telling us today.
Markets are weird right now
We’ll start with the world’s biggest bond market – the market for US government bonds – and an important caveat. Right now, bond markets – like stock markets – are being dramatically distorted by the US Federal Reserve.
The Fed is buying bonds like a kid with mom’s purse at an ice-cream van. This means that prices for US government bonds (Treasuries) are going up – higher demand drives up prices. As a consequence, as we see long-dated government bond yields hitting record lows (as the price goes up, the yield/coupon payments go down).
So, we have to ask: Is this signalling a long-term recession (which it would be doing, in a normal market) or is this just the distortionary effect of Fed buying?
There’s no easy way to tell. On the one hand, it seems reasonable to expect weak economic growth going forward. Many people are out of work, supply chains are disrupted, and Covid-19 seems to be just getting started in places like Brazil, India, and Russia.
On the other hand, given how much money central banks are printing, long-term inflation seems very likely.
In short, the bond market could well be signalling what economist Nouriel Roubini has warned of – a recession, followed by a mild recovery, followed by a global, stagflation-led depression.
Weird bond markets are propping up stock markets
Stocks are, at heart, a bond alternative. You take on more risk (because, again, you are not going to get your capital repaid, you have to sell your stock to someone else to get it back) but have a shot at higher returns.
Most big investment managers – think massive pension funds or sovereign wealth funds – would prefer to buy bonds, because they are less risky as they are higher up the capital stack. But when bond yields are very low, they move into stocks because bonds won’t deliver the returns they need. This pushes up stock prices because there is simply more money in a market of but so many securities.
Therefore, the Fed’s actions are having two distortionary effects: they’re keeping bond yields artificially low and propping up stock prices.
That’s a big part of why we see what we’re seeing. In SA, the JSE is recovering from its lows and government bond yields have fallen off their highs. This is a kind of echo of what’s happening globally. SA bonds are becoming more attractive because US, European, and Japanese bond yields are so low. This lowers SAGB yields. And lower SAGB yields pushes investors out of bonds and into stocks, which props up stock prices.
What is going on?
What does this all mean? Basically, we are in unchartered territory. In a more normal environment, we would expect to see risky assets losing ground and safer assets gaining it in the face of a global slowdown (in practice, we’d see everyone buy US government bonds and sell equities). Bond yields would fall – in other words, bond prices would rise – and stock markets would decline. Instead, because of what governments are doing, we’re seeing both bond and stock prices rising together.
So, we have distorted markets that are sending weird signals that people are struggling to read. Will we have inflation? Will we have deflation? Will we have deflation followed by inflation? Will the world economy recover quickly or will it recover a bit and then collapse under the weight of its various asset price bubbles?
There is really no way to tell right now. People claiming that rallying stock markets are a bullish signal are deliberately ignoring the impact of central bank action in pushing up stock prices (and other asset prices, for that matter). But people pointing to long-term low interest rates as a bearish signal are also ignoring central bank action in propping up bond prices.
We are travelling blind, and our normal compasses are being fiddled with – as if someone were standing behind us waving around a giant magnet as we search for magnetic north. Predictions, in this environment, are flimsy at best. Don’t trust anyone who tells you otherwise.
