Bond Yields Continue to Fall, Should the Stock Market Worry?
Stocks and bonds often move in opposite directions, especially when confidence in the stock market wanes. Given the correlation, does this mean that stocks are in trouble?
We want to be careful drawing assumptions about causation from evidence of things being correlated, and messing this up is one of the most common fallacies that we commit. There are probably quite a few beliefs that we have that are based upon this, where we may have something that may even be a contributing factor to something, but this means that there are often intervening factors that have to be present for the result to correlate.
Thinking that when bonds go up in price, stocks will be pushed down as a result is a good example of our not thinking clearly enough. However, this may have the appearance of validity, as when bonds go up, this is often from people pulling money out of stocks, so the two do go together a fair bit.
We do actually have a causal relationship of some potential here, as when money moves out of the stock market, it needs to go somewhere. If we see stocks go down in price a lot, during a bear market for instance, bond prices tend to do well a lot of the time, but not always, and this is where the intervening factors come in.
This increases the potential market for bonds of course, but the degree that this newly freed-up money makes it into bonds, and the degree that it affects bond prices, depends on a number of other things, how the bond market is faring generally, differences in currency valuations such as a strong or weak dollar, interest rate outlooks, and so on.
It is very well worth noting that among these potential causes, interest rate outlooks are by far the most influential, as bonds are not like stocks. Bonds are very much driven by fundamentals, and interest rates is the fundamental here that drives yields so much.
There Is Not a Strong Causal Relationship Between Stock and Bond Prices
Stocks going down causing bonds to rise or rising bonds causing lower stock prices is not direct causation, and instead functions as an influencing factor which may lead to a correlation, and often does. When we look to flesh out such a scenario to look to what influence these lower stock prices may have upon bond prices, one situation will often not be quite like another, and the other factors involved may exert significant influence to produce some real deviations from the usual correlations.
It is never wise to just go with the generalization, without seeking to refine our understanding, even though the generalization may be true more often than not and even very often, because given that there are cases where the correlation doesn’t work, we need to figure out whether our situation can be distinguished in a way that makes it more likely than not to be distinct.
A good example of this would be looking at investor outflows and using that as a model to predict stock market behavior. When investors are taking more money out of the stock market than they are putting in, this usually means that prices will decline, but not always. In 2019 so far, for instance, we have a net investor outflow, but stock prices have climbed in spite of this.
Stock buybacks are cited as the reason, but there are other ones, and in fact we can have less people in the market but the outlook of this lesser number of investors can be more positive. The people exiting can therefore be selling their stock to people who are pretty bullish, and stock prices are moved not only by now much money is coming in or leaving, but the outlook of the participants along the way.
To illustrate this, If tomorrow, we hear that China and the U.S. have struck a good trade deal, more people may enter the stock market with more money, but the big effect here would be that people will want more when they are selling their stocks, and people will be willing to pay more, due to the effects of the improvement on our outlook that this event would cause.
We can see instant leaps in stock prices one way or the other, and none of this is driven by inflows or outflows as this change does not involve any trades at all, let alone enough to change the price. This effect is the central driver of stock prices in fact and trumps everything.
As we can see, none of this is all that simple and there’s a lot more going on here than just bond prices. They do matter, but only to a certain extent, and only in certain cases, where the increase is caused to some degree by an interchange of assets between stocks and bonds.
When we look at this from the other side, by starting with increasing bond prices and then looking for this to cause stock prices to drop, as some are expecting right now, this makes even less sense. There is a number of reasons why the bond market becomes more bullish, and declining stocks is one of several.
There are two main reasons why we might see stocks and bonds move inversely like this, with the first one happening if the increase is due to people pulling out of stocks, and this pullout can cause a net decrease. We need stocks to be actually going down to call this one though, and if they are not, it simply isn’t valid.
The other cause is from a changing perception in the market which may be affecting both of them in a similar way. The way to tell this is, once again, to see if the markets are moving in concert. If they are not, we don’t have a correlation of any sort happening.
If We Want to Predict the Stock Market, We Need to Look at Stocks not Bonds
We might think that this all may be predictive though, just a people thought when we first had an inverted yield this year, inspiring a lot of talk about how this usually means a recession is coming and people valuing stocks lower for a time due to fears of this.
If we assume something such as an inverted yield or low bond yields will cause a recession 6 months or a year from now, because we see that when this happens, we usually do see the recession, this does not mean in any way that a given instance of an inversion makes it any more or less likely to see a recession.
There are just too many factors, and the inversion itself doesn’t do much of the work here, although the reasons behind it might. Something might bring up bonds and bring down stocks, or something might cause a recession that affects both in this manner, and even if this happens 8 times out of 10, we don’t know whether our current case is one of the 9 or one of the 2.
Knowing nothing else, we would be forced to adopt the raw probability of a recession of 80%, but there is more to know, and in our case, what we do learn is that while there is a risk of a recession, the odds of it aren’t even close to this high.
Demand for one or the other asset class is interdependent to a degree, and the demand for bonds is up, this can put down the demand for stocks, but not necessarily. We see momentum in the bond market as well, and investors may simply be riding the bull here just like they do in a bull stock market. It could be that the dollar is strong, a central bank is acting in a way to cause bond prices to rise, or from other factors, all of which can play a significant role in the bond market.
The biggest question here is why we would look at the price of another asset when we’re looking to figure out where we are with ours. Whatever the effect that bond yields declining has had on stocks, we will see it reflected in stock prices, along with everything else that influences them, in full measure.
It is not as if rising bond prices build up like a dam on a river would, and when it gets to a critical point, the dam breaks, because there is no dam here, just water flowing down river from bonds to stocks. All we have to do is measure the depth of the river to see what is happening, and if we think the water levels should be different, there is no arguing with the actual measurement, which in this case is stock prices themselves.
It’s not that there isn’t anything to learn from bond prices these days, and the big thing is that the bond market thinks inflation will be running low for quite a while. That’s actually a pretty reasonable prediction, and while economists play a role in this, the output is certainly colored by a lot of things, and therefore the actual predictions from the economists are more reliable than anything that can be inferred with speculation mixed in.
The 10-year yield has been declining by a fair bit since last October, and it has gone virtually straight down since. The stock market did go down initially, but rallied enough to recover its losses, so looking at bond yields would have us selling and staying home all the way since.
The most extreme historical lows for 10-year yields, where we dropped below 1.5% both times, in 2012 and 2016, were both in good years for stocks, and the economy did not suffer either. We’re nowhere near these lows right now. If 1.5% didn’t scare us, and should not have either, we really shouldn’t worry about 2.25%.
Recently, we have learned that inflation will be more modest than we thought, nicely modest in fact, and this in itself will bring down yields. Stocks can thrive in low inflation environments though, and our current long bull market is perhaps the best example of this, because this is a new era as far as low inflation is concerned, and the stock market has prospered well.
If we want to see where the stock market may be heading, we can look at both the economic projections as well as trends in the stock market, and neither are producing any real warning signs right now.
Paying attention to bond yields instead will just lead to our being confused. There’s a lot of confusion out there these days though, but fortunately, not enough people have acted upon this confusion to matter much.
Editor, MarketReview.com
Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.
Contact Monica: monica@marketreview.com
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