Shifting assets in a free market

WendyBG · May 25, 2022, 12:57am

In the “traditional” free market (before the Federal Reserve began massive monetary stimulus to suppress interest rates after 2000), investors brought a certain amount of capital to the markets, which they divided between stocks and bonds.

It was a zero-sum game. If investors put more money into stocks (usually when the economy was growing) they would put less into bonds. Putting less money into bonds caused their prices to drop, which caused interest rates to rise. Interest rates also rose during expansions because companies borrowed more money for productive capital investments.

During economic contractions, stocks fell. Investors shifted toward a risk-off trade. They sold stocks (driving stock prices lower) and bought safe bonds, such as Treasuries. This caused bond prices to rise and their interest rates to fall.

Investors could also sell their financial assets and move into cash. This would be like a retreating tide, draining money from the markets and causing the prices of all assets to drop together. (Each asset individually affected differently, depending on sales.)

Mike Shedlock (mishedlo, the original founder of this board) has just posted an interesting idea.

https://mishtalk.com/economics/top-idea-of-the-month-what-ne…

“Over the past five decades, only when the 10-year T-note yield plunged 135 basis points (on average) did the S&P 500 manage to make a bottom."

This makes sense. A fall in the 10-year T-note (10YT) yield is equivalent to investors saying, “I’m giving up on stocks. I can’t stand the uncertainty anymore. I’m buying risk-free Treasuries.”

Mish posts charts showing that stocks peak and begin to fall about the same time that Treasury yields peak and begin to fall. Stock prices don’t bottom until Treasury yields bottom. At that point, investors start shifting money from Treasuries back to stocks. Then Treasury prices fall and the yields start to rise again.

The 10YT peaked at the beginning of May. It’s beginning to fall.
https://stockcharts.com/h-sc/ui?s=%24TNX

https://www.wsj.com/articles/bonds-descent-stalls-amid-stock…

**Bonds’ Descent Stalls Amid Stock Turmoil**
**Treasury yields stabilize as investors worry about an economic slowdown and seek safe assets**
**May 23, 2022**
**...**
**On Monday, futures bets showed traders assigning a roughly 83% probability that the Fed will close 2022 with its [overnight] rate target between 2.5% and 3%...**

“Bonds’ descent” is equivalent to saying “rising yields.”

If the Fed raises the overnight fed funds rate to 3% and the 10YT yield is 3% the yield curve would be flat. If the 10YT yield falls, the yield curve would be negative – usually a harbinger of recession in several months.

This gives METARs a useful signal!

If this isn’t noise and 10YT yield begins to fall in earnest, we will watch it closely. Only after the 10YT yield bottoms and begins to rise will the stock market have bottomed.

The Fed could manipulate this by selling some of their huge book of Treasury and mortgage bonds. Will they? Who knows?

Wendy

MarkR · May 25, 2022, 10:24am

It was a zero-sum game. If investors put more money into stocks (usually when the economy was growing) they would put less into bonds. Putting less money into bonds caused their prices to drop, which caused interest rates to rise. Interest rates also rose during expansions because companies borrowed more money for productive capital investments.

I don’t see how it can be a zero sum game. And I certainly don’t see how investors “put less into bonds”.

The supply of bonds rose dramatically. Just treasury debt alone rose from $5.7T (2000, when the suppression of interest rates began) to $29.5T (2021). Corporate debt rose quite a lot as well. And mortgage debt rose substantially. If investors put less into bonds, who is holding all this new debt exactly? The fed only carries a fraction of it.
It’s probably not a zero sum game because when someone buys real estate, they essentially also create a bunch of new debt in the form of mortgage securities. So the choice are more than just stocks or bonds, it also includes real assets like real estate, and often that kind of transaction is combined - buy an asset (real estate, etc) AND at the same time create some new debt. And when the money changes hands, then it is again invested in bonds/stocks/real estate/etc. That doesn’t appear to be zero sum.

WendyBG · May 25, 2022, 12:58pm

MarkR, you make good points.

Why did I say “zero sum”?

At any ONE MOMENT, the amount of demand for assets will be a specific amount. It may grow or shrink in an hour, but at this moment there is a specific dollar amount offered by investors for stocks, bonds and other assets. That is the zero sum.

In the next moment, investors may want to buy more or less, and the supply of stocks, bonds, real estate, etc. may be more or less.

But at THIS specific moment, the investors have to choose among and bid on investments.

If stock investors (in aggregate) are frightened in this moment and sell stocks to buy Treasury bonds with the proceeds, the price of stocks will decline and the price of T-bonds will rise (yields will fall). Of course, those same investors have many other choices – to buy or sell other assets. But the stock and Treasury markets are both gigantic and very liquid so they have a lot of activity.

Let’s look at the broad choices of investments from a supply/ demand perspective.

“Supply” is the amount of assets in the market, which is constantly changing. Stocks, bonds, real estate and many other types of assets which all compete for investment dollars.

Let’s focus on the supply of bonds (debt). You mentioned how government deficits and mortgage debt increase the supply of debt. Let’s add corporate debt and trade deficits, which are continuously growing and at record levels. Not to mention personal debts, including over $1 Trillion in student loans. The total amount of debt in America is truly breathtaking. The Federal government alone owes over 100% of GDP and constantly growing. All borrowers compete against each other for lenders, paying higher interest rates (spread to Treasuries) depending on the bond market’s demand and risk assessment.

Federal Debt: Total Public Debt as Percent of Gross Domestic Product (GFDEGDQ188S) - not including state and municipal debt = 123%.
https://fred.stlouisfed.org/series/GFDEGDQ188S

The Fed has stopped buying additional bonds and intends to gradually reduce the amount of bonds they already own. (By running off their book.)

Now let’s talk about the demand from the lenders for this debt (bond investors). You reasonably asked, “If investors put less into bonds, who is holding all this new debt exactly? The fed only carries a fraction of it.” Great, this gets me thinking, too.

Federal Debt Held by the Public as Percent of Gross Domestic Product = 96%
https://fred.stlouisfed.org/series/FYGFGDQ188S

Federal Reserve Assets (including Treasury and mortgage debt) = $8.945 Trillion / $24.4 Trillion GDP = 36.7% of GDP
https://fred.stlouisfed.org/series/WALCL

According to the Federal Reserve and U.S. Department of the Treasury, foreign countries held a total of 7.55 trillion U.S. dollars in U.S. treasury securities as of September 2021. That’s another 31% of GDP.
https://fred.stlouisfed.org/series/GDP

Foreign countries with a trade surplus with the U.S. (China, Japan) are big buyers of Treasury debt. It’s a place to safely invest their dollars to make some interest while they avoid increasing the value of their own currency. (During the 2000’s, Fed Chair Alan Greenspan called it a “conundrum” when long-term Treasury yields didn’t rise when the Fed raised the fed funds rate. Actually, it was due to increasing U.S. trade deficits used to buy Treasury bonds.)

The Fed itself has deliberately suppressed real Treasury yields to negative during the Covid crisis. All other interest rates fall in tandem.

https://home.treasury.gov/resource-center/data-chart-center/…

What I don’t understand is why bond investors still continue to accept such meager real long-term yields. It can’t last forever, given the huge forecast government deficits.

Bottom line: I am looking for an actionable signal of a stock market bottom.

As you rightly pointed out, the Treasury bond yield signal will be blurry because there are so many moving parts to the asset markets. The many buyers of Treasuries will be fluid in their purchases. BUT – if enough stock investors (institutional, individual and transnational) decide that the economy is recovering and entering a growth phase, sell Treasuries and buy stocks…the stock market and Treasury yield will indeed bottom at the same time. The Fed also tends to raise the fed funds rate during expansions so this will add to the signal of rising Treasury yields during economic growth.

https://fred.stlouisfed.org/series/FEDFUNDS

Wendy

MarkR · May 25, 2022, 1:33pm

What I don’t understand is why bond investors still continue to accept such meager real long-term yields. It can’t last forever, given the huge forecast government deficits.

I’ve thought about it long and hard and the only thing I can come up with is the following. The only buyers of these kinds of bonds right now are:

Institutions that have no choice. This includes organizations that are required to buy treasuries (pre-funded municipal projects, etc).
Institutions that don’t care. This includes insurance companies that “don’t care”, because they are regulated, returns have little influence on their behavior, in the end premiums = claims - investment income + profit, and premiums are set by their regulator (or competition kind of but not really) such that profit is somewhere around 10%.
Unsophisticated savers. There are still people who religiously adhere to 60/40 (or some other variation depending on age) despite a 40 year bull market in bonds that suddenly ceased as bonds have hit negative real yields for a bunch of years. If your yield is negative, and rates rise dropping the value of your bonds, your overall return will be more negative. That could potentially continue for a number of years.
Speculators. People who think real yields will go more negative and want to earn capital gains on bonds as their prices go up. I suspect that this segment has been decimated over the last half year or so.

I cannot conceive of a normal investor, looking for yield or gains or whatever, actually sitting down and saying to themselves “I want to buy a 10-year or 20-year bond and collect a 2.5 - 3% yield for all that time, and then get my money back at the end”. Unless perhaps they expect a long bout of actual deflation coming our way. And the only time we’ve EVER seen real deflation for probably 50, 60, or 100 years, was once for a few short months in 2009 and a tiny negative in early 2015.

WendyBG · May 25, 2022, 2:01pm

I agree with you…long-term deflation isn’t in the cards. Mike Shedlock was a “deflationist” for a long time but I disagreed for many reasons, not least of which is that the Fed will monetize the Federal debt which is forecast to grow explosively with no increase of productivity.

The Federal Reserve has announced its intention of maintaining inflation at 2% so the real yield of a long-term bond with a 2.5 - 3% is essentially zero. Before the Fed flooded the banking system with negative-yield money, banks offered CDs with a positive real yield. But the Fed doesn’t care about conservative savers, many of whom are retirees who don’t want to risk their nest egg in the stock market.

The “normal person” is not a “normal investor.” Most people are not high net worth. They are rightly risk-averse, especially people who rely on their savings and can’t tolerate stock market volatility. The Fed’s actions have been very harmful to these people. Even 2% inflation eats away at the value of cash. Without safe alternatives to cash yielding a positive real rate, many people will fall further behind. High inflation exacerbates this.

Wendy

Hawkwin · May 25, 2022, 2:47pm

What I don’t understand is why bond investors still continue to accept such meager real long-term yields.

I don’t think they are, which is why the curve is so flat. Let’s not forget that the bond market just had its worst quarterly performance in 30 years. That is not an indication of “acceptance.”

That being stated, the futures market has priced in a return to relatively normal inflation in the next few years.

https://www.forbes.com/sites/garthfriesen/2022/04/20/forward…

Most financial markets have actively traded futures markets, which, when viewed together, describe a macro landscape that can be very different from the one today. The good news is that these markets predict that inflation is near its peak.

…

The one-year inflation rate beginning in one year, known as the 1y1y inflation rate, is 3.5%. While still higher than the average rate over the last decade, it is significantly lower than the current annualized rate of 8.5%. The forward inflation market tells us that investors think the CPI is near a peak and will slow dramatically over the next couple of years.

Of course short term Treasury yields are way up. The 2 yr note yield has more than doubled this year from around 0.75% to 2.7% at the end of April, but it also has slowly started to come down and now sits around 2.5%. The bond market has gotten well out and ahead of the Fed so many might be interested in capturing a yield not seen for over of a decade (absent a very brief period in 2019) with the expectation that if there is a recession, the fed will again cut rates, and yields will drop.

MarkR · May 25, 2022, 7:07pm

The one-year inflation rate beginning in one year, known as the 1y1y inflation rate, is 3.5%. While still higher than the average rate over the last decade, it is significantly lower than the current annualized rate of 8.5%. The forward inflation market tells us that investors think the CPI is near a peak and will slow dramatically over the next couple of years.

What was the 1y1y inflation rate a year ago? What did it tell us then?

MarkR · May 25, 2022, 7:33pm

The Federal Reserve has announced its intention of maintaining inflation at 2% so the real yield of a long-term bond with a 2.5 - 3% is essentially zero. Before the Fed flooded the banking system with negative-yield money, banks offered CDs with a positive real yield. But the Fed doesn’t care about conservative savers, many of whom are retirees who don’t want to risk their nest egg in the stock market.

I think they are lying. Mostly to themselves. Deep down they KNOW that in the event of a deep recession, that causes unemployment to spike, even with some inflation (>2%), they will still “crack” and stop raising rates real quickly, and even lower them some. And they will accept inflation of 3% or even 3.5%.

The “normal person” is not a “normal investor.” Most people are not high net worth. They are rightly risk-averse, especially people who rely on their savings and can’t tolerate stock market volatility. The Fed’s actions have been very harmful to these people. Even 2% inflation eats away at the value of cash. Without safe alternatives to cash yielding a positive real rate, many people will fall further behind. High inflation exacerbates this.

But it is just the opposite. The “normal” state is for low real yields, very low. Too low to make them worthwhile for long-term savings for ANYONE, especially low or moderate income folks. They are not high worth PRECISELY because of using too much fixed income and too little equity over their 40-45 year careers. It’s really easy to understand, fixed income will get you perhaps 2% real yield over 40 years, while equity investing (just use any wide index, it doesn’t really matter much which one) will get you 5-7% real yield over 40 years. Compounded over all that time, it is a HUGE, a MASSIVE, difference.

Take a look at this chart, and you can expand it to 50, 80, 100, or even 150 years if you like. You will see that real interest rates spend quite a lot of time near zero or even below zero, and only sometimes exceed 2%, and VERY rarely exceed 3%. The high real rates are the anomalies, like in the 80s for a short period of time.

https://www.longtermtrends.net/real-interest-rate/

Furthermore, there are real macroeconomic reasons why high real rates can’t, and shouldn’t, be a regular thing for government issued securities. But I will leave that for a different post someday.

Hawkwin · May 26, 2022, 11:02am

What was the 1y1y inflation rate a year ago?

About 4%.

https://ycharts.com/indicators/us_oneyear_ahead_inflation_ex….

Relatedly:
https://www.newyorkfed.org/microeconomics/sce#/
The April 2022 Survey of Consumer Expectations shows that inflation expectations fell to 6.3 percent at the one-year horizon and rose to 3.9 percent at the three-year horizon. Households remained positive about their labor market prospects with earnings growth expectations stable at its series high and job loss expectations hovering near its series low. Household spending expectations over the next year also rose to a series high. However, perceptions of credit access relative to a year ago fell for the fourth consecutive month, and expectations of credit access one year from now declined to a series low.

That being stated, I am not sure it matters in this context.

Prices (and behavior) are set based on expectations both for stocks and bonds - and less so on the eventual reality.

flyerboys · May 26, 2022, 10:18pm

A great informative and even deep thread on a hopelessly dreary topic.

Thank you all upthread. I actually had to think hard often, and I learned a lot.

What METAR is for!

david fb