There has been much angst spilt on the social media timelines over the last week, not the least of which has been related to a sell off in stocks and a commensurate rise in bond yields. Now for many participants in markets, stocks are the ‘be all and end all’ of their involvement in markets.
However, the interplay between stocks and bonds is critical, not just from a perspective of alternative asset classes, but also how developments in the bond market tend to affect equities.
This piece will take you down the rabbit hole a little so bear with me.
The nature of the reader of these posts and newsletters varies from sophisticated to novice investors and as such, the sophisticate will bear with me as I attempt to cover some basic concepts first. If you would like to skip ahead, click here.
Bonds come in all shapes and sizes. Firstly, a bond is a debt instrument which entitles the holder to interest. The interest may be paid out as coupons or rolled up to maturity (Zero coupon bonds). For the purposes of this discussion, we will only discuss nominal bonds (inflation linked bonds are another more complex variant). Bonds also tend to have a specific maturity (end) date (we will not discuss perpetual bonds today).
The value or price of a bond fluctuates, like an equity and is determined by changes in interest rates and/or credit risk. Bonds are issued by sovereigns and companies and as such, hold different credit risk profiles. (This is where a credit rating comes in). I won’t go into complexities (and convexities) of how bond prices change as time passes or interest rates change save for a few simple concepts.
Bonds are often referred to by their yield. The key thing for newcomers to note is that yields and prices move in inverse or opposite directions. I.e.: if the price of a bond goes up, its yield decreases. If the price of a bond goes down, its yield increases.
Another key concept is the yield curve. You will have heard the term. What is a yield curve? A yield curve is merely mapping bonds of the same credit quality with different maturities. For example, the curve below is the US yield curve at the time of writing. Ie: the same credit quality (US treasuries), mapped to their respective maturities.
An upward sloping yield curve is the ‘normal’ convention as investors will aim to be compensated for their term risk (holding an investment longer) by higher rates. The short end (early maturity) rates are generally determined by policy makers like the Fed. The longer end rates are generally determined by the short end plus any associated inflation risks (or expectations) as well as credit risks over time. In a global sense, one could argue that UST’s are the ‘risk free’ rate.
Ok so this is the yield curve you’ve heard so much about… So What?
Well firstly, yield curves are not static. They change daily. The curve I illustrated above is made up of 12 separate points. Each represents an individual UST maturity. As such, not only can the ‘level’ of the yield curve change, but so can its shape. This is because not all point’s move at the same time or by the same amount.
I have created some stylized examples below which show 2 scenarios. The first is what you have heard a lot about recently, a Steeper yield curve. Near term rates stay anchored but long term inflation expectations see long end yields rise. This steeper yield curve means the market is expecting higher risk (possibly inflation) in the long term and wants to be compensated for it. This is akin to what’s spooking markets currently.
The second, is a scenario which got a lot of press time a few years ago as the FED was tightening. It is called an inverted yield curve. This is where short end rates are much higher than long term rates. It is often seen as a precursor to a recession as short end policy rates are hiked while long term inflation expectations are contained. This is not the case currently.
Ok, now that the primer is out the way, lets get into why this caused the scare in markets:
Unless you’re buying stocks like TikTok ‘pros’ who ‘buy because its going up and sell because its going down’ you will know that one of the most common ways of valuing a stock or a company is called the discounted cash flow model .
Effectively, investors will take the anticipated future cash flows of the business into account and ‘discount’ these to the present. This discount is determined using a combination of an equity risk premium (beyond the scope of this post) and the risk-free rate. The risk free rate used is generally the yield on the relevant point of US treasury curve.
Simplistically, the higher the discount rate (or yield), the lower the present value of the security or stock being priced. We will use the 10 year yield as the key reference point. US 10 year yields have been trending upward for some time now.
At the start of 2020, they were around 1.8%, falling to around 0.5% in the middle of last year and has been rising since. They are currently around 1.4%. Why the rise? Well, we are moving through the pandemic and given large scale monetary and fiscal stimulus, expectations are that once things kick into full gear, inflation will begin to rear its ugly head.
Is it all about the yield curve?
But is the US 10 year yield or even policy the right way to look at things? Obviously, its not as simplistic as that. Rates markets and expectations are a whole different ball game with lots of interdependencies.
Equities can’t just be the inverse of interest rates. The chart below indicates that while the inverse correlation is clear (I have inverted the yields for ease of viewing), that one could argue that equities are merely playing catch up to systemically easier monetary policy.
The global financial crisis saw unprecedented monetary policy and rates fall to zero effectively. However, the ‘zero lower bound’ posed a problem for analysts who recognized that the massive stimulus from the central bank in the form of large scale asset purchases meant that the ‘effective monetary policy rate’ was actually below zero.
The chart above shows that there is an uncanny relationship between the Fed’s balance sheet and the S&P 500 and while not necessarily causal, is worth noting. In fact, I have modelled the explosion in equity markets against balance sheet expansion among all major central banks and it is a recurring theme and plays well to the discussion I wrote about regarding fiat money here and here.
I prefer to look at the ‘Shadow rate’ to inform how easy or tight monetary policy actually is. A ‘Shadow Fed funds rate’ was developed which took into account the effect of QE and other non-conventional stimulus measures.
Now, the Shadow rate is not new and was introduced in academia in 1995 and has been refined. The model by Wu and Xia in 2016 has become the recent standard. For those more technically minded, here is a link to the Atlanta Fed page referencing this and other works (Wu-Xia Shadow Federal Funds Rate – Federal Reserve Bank of Atlanta (frbatlanta.org)
Whenever policy rates are above 0.25% it effectively mirrors the implied one month interest rate. The real value of this indicator is below 0.25%. Between 2010 and 2015, this was a very instructive tool in calibrating overall financial conditions. The shadow rate has now dropped back into negative territory following the pandemic and is worth watching again. It is presently around -0.42%.
In and of itself, this is not instructive. In this piece here (Risky Business) I covered some of the risk flags and if you haven’t read it, it’s a good complement to this article. In Risky Business, I looked at how the S&P 500 was trading at close to 2 standard deviations above its own trend. Coupled with CAPE ratios and other indicators, it looks fully priced. The Shadow rate is another tool I look at to inform whether we should be afraid or greedy.
While the S&P 500 is almost 2 standard deviations above its own trend, Shadow rates are not as restrictive as they were 2 years ago and in fact are in line with its own trend and currently accommodative. Near terms rates look well anchored given the rhetoric and policy direction from major central banks, so inversion of the curve (discussed in the primer above) is not likely anytime soon.
The relative between these two ratios or standard deviations discussed above is instructive and when viewed conjointly as an indicator, do not suggest an outright risk flag to an imminent correction in equity markets.
That said, no single indicator is perfect and markets remain extended by many measures which means that it pays to be vigilant. The VIX (also discussed in Risky Business) continues to make higher highs in the short term and this is a concern.
Stocks are expensive, but so are bonds. With low and negative yields in some jurisdictions, stocks become the only alternative. At close to zero yields, the price action on bonds becomes the main driver of return and it has ironically become the risky trade as well.
You will forgive the cross referencing below but these issues are all interrelated and some of the newer readers may have missed the old content.
All asset prices are beholden to the fiat currency in which they are denominated and with large scale monetary and fiscal largesse, there is little place to hide. The genuine rise of crypto currencies (not the hype trade which may be damaging, but the underlying ideological thesis) is a symptom of these dislocations and will likely be with us for sometime. For those who missed it, I covered some of my views on Crypto in my podcast episode : Check it out.
Some would even argue that we are living through a Modern Monetary Theory experiment. I also spoke about this in my podcast a while back and more recently did an interview on Moneyweb for those interested, links here and here.
In this environment, don’t lurk in the shadow of shadow rates and don’t shy away from the yield curve. Stay ahead of the curve, educate yourselves and keep learning. That what Moe-Knows is about. A little tongue in cheek, I’d like to end with a quote from Tennyson’s Ulysses:
“To Strive, To Seek, To Find and not to Yield!”