With US 10-year bond yields around 1.25% (as of Thursday July 22) the question is, what is the bond market telling us?
Some say the bond market is pointing to stagflation from 2022 and beyond. Others say yields will rise because of inflation, and that these low yields are “transitory”. Other say the low yields point to the continuation of the pandemic with the Delta variant.
Then there are others who think at the bond market is not telling us anything anymore. The low yields we are seeing, despite inflation, are probably a reaction to the liquidity created by central banks. Let us not forget at the Fed the ECB and the Bank of Japan are all continuing to create liquidity at a record pace. So maybe the bond market it is not telling us anything anymore because it can’t.
So where does this leave equities? The answer is by themselves. Stocks do not have bonds to give them a hint of what might happen in the future. And while analysts, economists, and pundits alike are all confused about what the bond market is saying, it’s probably safe to say we should not look to bonds for any kind of direction.
The bottom line is that market participants are very confused as to what the bond market is saying. This confusion stems from the fact at the bond market is giving us conflicting signals based on what we have been conditioned to think for many years now. Maybe low bond yields are a bad omen for global growth, or perhaps not. One thing is true, this is not your grandfather’s bond market.
Up to about 50 years ago, inflation was the main worry of central banks, primarily because high inflation eroded consumer purchasing power.
Today however this has changed, and the main objective is economic sustainability. By this I mean Central Banks want a continuation of growth with or without inflation. Besides, why increase interest rates and crash the economy making a mess of things, only to lower interest rates to try to inflate the economy, and then do the entire thing all over again?
Many say these asset purchases will cause inflation. Yes, it might happen in the future, but over the past 30 years or so, the lessons to be learned are that we are not in the 50s – 70s anymore.
Which brings us to the discussion on when the Fed will lower or even eliminate the 120 billion dollars in bonds it purchases each month.
My guess is that the Fed will continue these purchases for longer than we imagine. The reason is, the last thing the Fed wants are higher interest rates. Higher rates will affect negatively both the labor market and asset prices. Both stocks and real estate prices are likely to trend lower, which will have an impact on the wealth effect, which will eventually impact the real economy.
Also, contrary to many years ago, the US government today has a much higher debt load. Higher interest rates mean more dollars to service this debt. And with fiscal spending still running, the last thing the US Treasury needs are higher outlays for servicing its debt.
So, while you will not hear the Fed saying it, higher interest rates are not what it wants, even if inflation persists. Insofar as what risk assets will do, we do not know. While logic dictates the liquidity created should continue to be supportive for markets, practically speaking the outcome is not a given.