BK: Is the Stock Market Missing the BIG Shift in the Bond Market?
There is something funny going on in the bond market – weaker economic news is leading to higher bond yields. This is not just unusual, it is completely counter-intuitive. The conventional wisdom is that the yield on the 10 year government bond should reflect the long run GDP growth rate. For example, the current yield on US 10 Year Treasury Note is 1.66%, reflecting a stagnant GDP growth rate just shy of 2%. But what if this relationship is no longer valid?
Yesterday the US Industrial Production (IP) data showed that for the 12th consecutive month in a row IP fell on a YoY basis.
A negative YoY growth rate in Industrial Production has occurred 20 times since 1920, during 18 of those times the US economy was either in or on the verge of recession. The weakness in Industrial Production was coupled with a fall in retail sales – which together suggests the US economy is heading toward recession. Given the traditional relationship between GDP and bond yields one might expect that yields dropped…they did not.
US Ten year yields climbed 2bps on the negative economic news. What’s even more striking is that since the end of August the US economic news has consistently deteriorated (as measured by a negative Citi Economic Surprise Index) but the US yield curve has steepened by 17 bps!
Citi Economic Surprise Index
US Yield Curve: 10 Year – 2 Year Rates
This anomaly could be in large part due to the Bank of Japan (BoJ). The BoJ is set to announce a review of its monetary policy and the bond market is starting to price in a change in policy. The current policy of all central banks conducting QE is to buy bonds – they start with shorter maturity bonds and then move out to the 10 – 40 year range when they run out of short term bonds to buy. This is what the BoJ has been doing…until recently.
Recently the BoJ has not been buying longer dated bonds and the market has taken this as a signal of a shift in policy. The Japanese bond market is pricing in a new policy from the BoJ that targets a steeper yield curve. The intent of this policy is to encourage the banks to lend. One of the big problems with QE is that it flattens the yield curve and makes bank lending less profitable. The thinking now is that the BoJ wants banks to lend to stimulate the economy, therefore the BoJ is going to engineer a steeper yield curve.
This inference by investors in the Japanese bond market is filtering throughout all global bond markets, most notably the US bond market. It is this potential shift in policy that could be causing the US yield curve to steepen while the economic data erodes. US bond investors are not pricing in a rate hike from the FED, but rather the potential that the Fed follows the BoJ in engineering a steeper curve if/when a recession occurs.
What does this mean for the stock market?
The most obvious sector impacted is the US banks – they will benefit from a steeper yield curve. And given the fact that they are relatively cheap and pay a decent dividend more investors could flock to this sector. On the other side of the coin is the consumer staples and utilities, which have been the beneficiaries of the hunt for yield/ TINA (There Is No Alternative). If there IS an alternative then these sectors could get hurt.
If you thought the recent volatility was stomach churning, you ain’t seen nothing yet if/when global monetary policy makes this big shift.