Do you feel more optimistic than a year ago? Despite more negative headlines and political turmoil, bond markets are signaling more optimism surrounding future growth than a year ago.
Nominal yields around the world are much much lower than their historical averages. We actually see negative rates in some European nations. That being said, things are improving. Long-term growth expectations are heating up:
Since a year ago (See: Column “Delta One Year”), all yield curves have steepened, with the Italian yield curve steepening the most severely. In all cases, the 10-year yield rose/fell faster/slower than the 2-year yield. This signals more demand for short term bonds compared to a year ago. Since a month ago (See: “Delta One Month”), all yield curves, save for Italy, have flattened. This signifies more demand for long term debt than short term debt. See Table 1:
It seems sentiment has changed since a year ago. Within the last month, more investors have loaded into longer-term fixed income securities. This is a yield-seeking activity. There has been a global flight to longer term, higher yielding fixed income securities within the last month. This point of view describes investors preference for more yield (less long-term risk).
As yields rise, the opportunity cost of owning stocks rises. More investors will flock to bonds as yields become more attractive. This dynamic causes equity markets to follow bond markets. This point of view describes investors preference for more return i.e. more yield.
As the yield curve steepens, expectations of future long-term growth have risen relative to short-term growth expectations. As investors become more optimistic on the economy, more money will pile into riskier assets, i.e. stocks. I call this the Future Expectations argument. Under this argument, a yield curve steepening results in higher stock prices. This argument describes an investors preference for risk. More expected growth = more willingness to accept risk. Under this argument, bonds and stocks are inversely correlated.
As the yield curve steepens, yields rise and prices fall on the long end of the curve. As yields rise, equity investors looking for yield will sell equities in favor of bonds. As long term yields rise, equities will fall. This is the Opportunity Cost argument. Under this argument, a steepening yield curve will result in lower stock prices. This argument describes an investors preference for yield. Under this argument, bonds and stocks are positively correlated. (For more on Stock/Bond Correlation, see PIMCO).
Given today’s nominal yields & equity values:
Investors are yield-seeking at current nominal yields, thus the Opportunity Cost argument dominates the Future Expectations argument. When the yield curve flattens today, equities will rise tomorrow and when the yield curve steepens today, equities will fall tomorrow. As nominal yields rise, I believe the relationship will flip, and the Future Expectations argument will dominate.
In 12 out of those same 12 markets, yield curves have steepened over the last year. In 11 out of 12 markets in our sample, yield curves have flattened within the last month. Should this change of sentiment continue, yield curves will flatten and equities will continue to rise. However, I expect the long-term trend to prevail, with yield curves continuing to steepen throughout the next year.
When the ECB and BoE decide to stop QE and raise short term rates, I expect yield curves to steepen. As yield curves steepen, equity markets will fall as investors switch to bonds from stocks. Investors will flock to safety, rallying bond markets.
Watch the ECB and BoE for signals on bond markets. See German Bund Yields.
Thanks for reading,
Further: “What the hell are you talking about?”
A common measure of bond market sentiment is the different between the yield on a 10-year government bond and a 2-year government bond. For example, the spread below is 1.25%. (Note: not the actual yield curve below.)
Review: There are two types of yield curve steepeners: Bull and Bear. A bull steepener short term rates are falling faster than long term rates. This means the 2-year fell faster than the 10-year (and both rates fell); recall, prices rise as yields fall. A bond bull market is one where yields fall. A bear steepener is one where the 2-year rises less than the 10-year, and both rates rise. Prices on bonds fall as yields rise.