EQUITIES AND BONDS ARE BOTH RISING – ONE OF THEM HAS TO BE WRONG!

The 2014 government bond conundrum continues: Bonds and equities continued to rise in unison, while economic logic and history suggests that they should move against each other. The chart above illustrates this through the comparison between stock market moves and yield changes (which move inverse to bond values). Normally when stock markets rise, bond yields rise as well. This is the result of selling pressure on the lower risk, lower return potential bonds in favour of equities, which drives down bond values. This reduced value increases the relative yield their fixed coupons payments constitute vs the market value of the bond.

Since the beginning of 2014 this rationale appears to have broken down and particularly in the past weeks yields have fallen, bond values rallied while stock markets have also reached new highs. So the question many market players are asking is: Who is wrong (and therefor in for a fall) the bond markets or the stock markets?

There are a number of explanations for what we are experiencing:

1.    A previously failing economy is recovering, reversing earlier parallel falls of equities and bonds

2.    Bond investors foresee trouble that equity investors don’t see

3.    Markets expect quantitative easing measures in the future, driving up bond demand and pushing investors up the risk curve into equities

4.    Correction of a previous overreaction of inflation fears by bond investors

5.    Fiscal repression: Financial institutions are ‘forced’ to purchase government bonds

 

All of the above are currently hotly debated and as stated before, I believe that we are experiencing a temporary correction of bond yields after bond investors have come to realise that inflation is going to rise less quickly than they anticipated during the 2013 government bond sell off. As always it is most likely not a single reason explaining market action. There are good arguments that banks, insurers and pension funds are forced by regulation to stock up their government bond holdings, while there is a supply shortage as governments are borrowing less and central banks are still holding vast amounts of the existing stock as a consequence of their QE programs. There is a bit of fear as well, resulting from the disappointing Q1 growth figures around the world, which some interpret as the harbinger of a turning of the economic cycle, while most see it as a temporary blip as a result of adverse weather in the Northern hemisphere.

During the past week, argument 3 received some additional support, when Eurozone money supply figures showed that the monetary base in the currency union is still shrinking (see chart below), while the economy is clearly expanding once again. This has made additional monetary easing by the ECB all but a certainty, following their announcement last month that they would do so in their next meeting should the deflationary pressures persist.

 

I somewhat suspect that markets are overestimating the likely ECB announcement for Thursday next week. Clearly there will be some sort of action, but I believe it far more likely that the first step will be a tinkering with the already low interest rates towards an experiment with marginally negative rates for bank deposits. In combination with the further improving macroeconomic environment I am expecting the ‘bond-conundrum’ of 2014 to pass in the foreseeable future. So bonds are the asset class more likely to retreat over the summer, however that is not to say they are wrong at the moment, but rather that they were wrong last year, when they fell far more than the slow economic progress warranted.

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