August 19, 2003

Decoupling Equity and Bond Markets?

The Economist's Buttonwood column wonders how it can be that wild swings in the bond market can leave the stock market unaffected:

Economist.com ...Normally, high interest-rate volatility leads to high equity volatility (though not necessarily the other way round, because when equities are having a tough time, investors flock to Treasuries, which tends to depress volatility). There are good reasons for this: think of the effects volatile interest rates have on borrowing; on planning; on equity-valuation models that plug in interest rates; and on banks' risk-management models, which force them to dump positions--wherever they may be--when losses mount and volatility rises in one part of their trading business. Oh, and then there are the systemic concerns and rumours about this or that investment bank or hedge fund getting into trouble when markets move sharply. In recent years the VIX, widely used as a proxy for systemic concerns, has spiked sharply at such times. This time, it has fallen.

Perhaps the Treasury market is now at one with the equity market: higher rates simply reflect a healing economy and higher demand for capital. On this view, as the economy recovers--and the evidence that it is enjoying at least a short-term fillip grows by the week--so the demand for capital and its price (interest rates) rises. But this does not ring true. American companies still have a lot of excess capacity at home, and thus demand for money for new investment is still weak. And it also neglects the extent to which the equity and bond markets seem to be ignoring each other. If history is any guide, there should have been at least some systemic flutters, if for no other reason than it is highly likely that a big institution somewhere has lost bags of money, and because the mortgage-backed securities market has tended to fall apart at such times. It certainly did in 1994.

Or perhaps the equity market has studiously ignored what the bond market has been up to for the good reason that the latter's recent gyrations have been only tangentially connected with what is happening to the real economy and short-term rates. In 1994, the Fed was in the process of doubling interest rates; this time, whatever your view about its communication skills (and there are many bond traders who might wish they were better), it has hinted repeatedly that it will leave rates at 1% for a long time to come.

Long-term rates have perhaps been having a wild time over the past few months for other reasons. In May, foreign central banks, especially those from Asia, bought more than $100 billion of Treasuries, largely to stop their currencies appreciating against the dollar. All that new money pushed down yields. Of late, demand from those same central banks has all but evaporated. Then there are the activities of Fannie Mae and Freddie Mac, the two American government-sponsored mortgage giants, which Buttonwood mused on last week (see article), and whose hedging activities have hugely exacerbated the moves in the Treasury market, both up and down. They have had to sell an awful lot of Treasuries lately to hedge their positions...

Posted by DeLong at August 19, 2003 12:26 PM | TrackBack

Comments

Huh? The bond market peaked on June 13. The S&P peaked on June 17. Bonds have sold off sharply, but interest rates are still low by historical standards. There is a link between bonds and stocks, but not a short term link. What is the Economist puzzled about?

Give me a choice between Exxon Mobil with a 2.71 yield and a 14.65 p/e ratio, and I buy Exxon every day rather than a 10 year treasury at 4.4%.

Bonds, especially treasuries, still do not seem attractive. There are other assets including stocks that selectively are attractive. Besides, any institution that did not hedge its bond portfolio when the 10 year treasuty yield was approaching 3.11% deserves to lose lots and lots of money. The call was absurdly easy.

Posted by: anne on August 19, 2003 12:51 PM

"Bonds, especially treasuries, still do not seem attractive" - anne, you said that a couple of days ago when they yielded above 4.5 and now yield is below 4.4% I hope you didn't party away all your trading gains from your short position, because last days it has cost you some...

Posted by: Mats on August 19, 2003 01:25 PM

the call was absurdly easy? retrospective ones always are. your prospective call on XOM vs the ten-year will be a lot easier to test later.

in re putative market decoupling, I think Morgenson's NYT column on mortgage-backeds was interesting. you can see a reprint at IHT's site, http://www.iht.com/articles/106715.htm

Posted by: wcw on August 19, 2003 05:19 PM

the call was absurdly easy? retrospective ones always are. your prospective call on XOM vs the ten-year will be a lot easier to test later.

in re putative market decoupling, I think Morgenson's NYT column on mortgage-backeds was interesting. you can see a reprint at IHT's site, http://www.iht.com/articles/106715.htm

Posted by: wcw on August 19, 2003 05:24 PM

the call was absurdly easy? retrospective ones always are. your prospective call on XOM vs the ten-year will be a lot easier to test later.

in re putative market decoupling, I think Morgenson's NYT column on mortgage-backeds was interesting. you can see a reprint at IHT's site, http://www.iht.com/articles/106715.htm

Posted by: wcw on August 19, 2003 05:29 PM

the call was absurdly easy? retrospective ones always are. your prospective call on XOM vs the ten-year will be a lot easier to test later.

in re putative market decoupling, I think Morgenson's NYT column on mortgage-backeds was interesting. you can see a reprint at IHT's site, http://www.iht.com/articles/106715.htm

Posted by: wcw on August 19, 2003 05:34 PM

Sorry folks, I think selling the 10 year treasury short at 3.75% or 3.5%, let alone 3.11%, was a breeze. The strategy was discussed on Wall Street Week in May. Shorts taken when the 10 year treasury was in the 3's should be covered by 4.2% or 4.3%.

Right now there are lots more interesting investments than bonds.

Posted by: anne on August 20, 2003 11:09 AM
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