Selasa, 07 Agustus 2012

The bond/equity disconnect

Very low yields on Treasury securities—and on most developed country sovereign debt, for that matter—are symptomatic of a market that holds out very little hope for growth, and a market that believes that central bank accommodation for an extended period is necessary to (at worst) keep the economy from sinking into another recession or (at best) pump up growth a little. There has been a fairly good correlation between equity prices and interest rates because of this perceived connection between weak growth and low interest rates—until late last year, that is. In the U.S. we now see equity prices approaching post-recession highs, while bond yields are still extremely low. What does this mean? 

One possible answer is that even though equity prices are nearing a post-recession high, they are still depressed compared to earnings and thus reflect a market that is very reluctant to see any good news on the horizon. According to Bloomberg, the trailing 12-mo. P/E of the S&P 500 is now 14.2, and the expected P/E is now 13.1. Both those ratios are substantially below the 16.6 average P/E ratio over the past 50 years.

And P/E ratios are very low considering that corporate profits are very close to record high levels compared to GDP. Very low P/E ratios are thus best interpreted to mean that the market is very pessimistic in regard to the future potential of profits. In a sense, the market is priced to a significant decline in profits, and that would imply that the market believes that growth is going to be miserable in coming years. This market is not optimistic at all. It was extremely optimistic in 2000, as we now know, when P/E ratios were extremely high but corporate profits as a % of GDP were relatively low; back then the market was priced to a continuation of robust rates of growth for as far as the eye can see. Today, in contrast, the market is priced to doom and gloom.

As this last chart shows, the bond market is not entirely oblivious to the improvement in equity prices. The 5-yr, 5-yr forward breakeven inflation rate that is derived from TIPS and Treasury yields (the Fed's favorite measure of inflation expectations) has moved up more or less in line with a stronger equity market in recent weeks, and is now at a one-year high.

My interpretation of all this is that equity prices are improving not because the economy is getting stronger, but because the economy is not deteriorating to the extent reflected in bond yields. Since the economy is not getting materially stronger, the bond market still expects the Fed to stay on hold for a long time, and so Treasury yields remain extremely low. But now the bond market is sensing that the risk of a Fed overshoot—i.e., not reversing its accommodation in a timely fashion—is rising, and that means that inflation could be somewhat higher in the future than the market had been expecting. Treasury yields are not going to rise meaningfully (thus "catching up" to equity prices) unless and until the economy proves to be much stronger than it is currently perceived to be.

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