US Stock Markets: The Incompatibility of Rising Stocks and Rising Bond Yields

Facts do not cease to exist because they are ignored. ― Aldous Huxley, Proper Studies

The seeming irony is that gains in the US financial markets appear to be narrowing down to the stock markets.

As previously explained[1] in 2009-2011, global stock markets, bond markets and commodities synchronically boomed. This broad based Risk ON environment started falling apart as BRICs began to weaken in 2011. This has been followed by swooning commodity prices over the same year.

Recently, market infirmities have spread to the global bond markets and ex-US stock markets.

As US stocks surged Friday due to “strong jobs”, which had been accompanied by a huge spike in bond yields, select American benchmarks such as Canada’s S&P TSX, Brazil’s Bovespa, Mexico’s IPC and Argentina’s Merval index took on the opposite direction[2].

Instead of cheering along with Wall Street, these ex-US American markets seem to be haunted by soaring bond yields.

In the US, rising interest rates seems incompatible with a sustained stock market boom.

I have noted of reactions of the S&P 500 to every incidences of rising 10 year UST yields since the bond bull market began in 1980s.

The Wile E. Coyote Moment

I call rising stock markets, in the face of mounting systemic leverage and rising yields as the Wile E. Coyote moment. When stock markets become objects of rampant and excessive speculation fueled by bubble policies, and whose boom has been financed by leverage, stock markets undergo or endure boom-bust cycles. 

The recent US 2003-2007 bubble cycle should be a noteworthy example. The booming S&P 500 (red) had actually been a symptom of a blossoming mania in the US housing markets. The latter peaked in early 2006. 

Yet the stock market continued its ascent despite increasing signs of cracks in the housing amidst climbing 10 year UST yields (blue line). 

The S&P’s rise has been partly financed by cheap credit as evidenced by the record net margin debt (see below)

Eventually the periphery to the core dynamic via the broadening implosion of the US housing markets slammed the banking system hard. A banking and financial crisis ensued. The S&P got crushed. The one year plus bear market cycle reached its trough in 2009.

Net margin debt (green ellipses) has been in near record territory today as it had been in 2007 and in 2000 or during the dotcom bubble[3]. The two prior episodes of bubble cycles, including today, shares the same characteristic: debt financed stock market boom.

A further implication is that today (or soon) will likely share the similar dynamic as in the past: a forthcoming bubble bust.

When rates of return from speculation are overwhelmed by the cost of servicing margin trading debt, the eventual result is either a margin call or forced liquidations. Boom turns into bust.

I would further add that much of the recent stock market growth has been via stock buybacks which has reached a “record”[4].

And a lot of these buybacks has been financed via the bond markets due to distortions from tax laws and from the allure of easy money, as previously discussed[5]

Rising bond yields will put to test the interdependence of stock markets with the bond markets. 

In the dotcom bubble days[6], again the same dynamic can be seen: rising stocks powered by expanding debt eventually had been terminated by elevated 10 year bond rates.

The dotcom bubble bust bottomed in 2002 two years after the bear market cycle surfaced.

A more interesting case is the Black Monday stock market crash of October 19, 1987[7]. This fateful day occurred just a little over two month after the assumption of Mr. Alan Greenspan as former US Federal Reserve chairman in August of 1987[8]. Mr. Greenspan’s action of cutting down Fed Fund Rates to produce negative real yield became the operating standard of financial market rescues that earned such policy, the moniker of the “Greenspan Put[9]”

Prior to the crash, the S&P soared along with the 10 year UST yield. The end result was a horrific one day 22% crash for the Dow Jones Industrials.

According to an investigative study by the US Federal Reserve on the 1987 crash[10]: (bold mine)

However, the macroeconomic outlook during the months leading up to the crash had become somewhat less certain. Interest rates were rising globally. A growing U.S. trade deficit and decline in the value of the dollar were leading to concerns about inflation and the need for higher interest rates in the U.S. as well

A case of déjà vu?

In short, rising stocks and rising bond yields again signify as a deadly cocktail mix.

Not every incidence of rising yields led to a stock market crash though.

1994 was known for a harrowing bond market crash. 10 year yields fell by more than 200 bps. Because there has hardly been a preceding stock market boom, there was neither a bear market cycle nor a stock market crash. The S&P traded sideways then.

What the bond market crash instead claimed had been Mexico’s Tequila or 1994 economic crisis[11], California’s Orange County bankruptcy[12] and partly the culmination of the Savings & Loans Crisis[13].

Nonetheless the post bond market collapse fuelled a trailblazing run in the stock market.

Finally, the conclusion of the stagflation days of the 1980s ushered in the golden days of US financial asset markets as both bonds and stocks boomed for three and two decades respectively.

When former Fed chief Paul Volcker wrung out inflation in the system by reducing money supply which sent 10 year UST yields to over 15%, the stock markets tanked as the US economy succumbed to a recession.

The S&P rallied by almost 70% from late 1982-84. Unfortunately rising UST yields again took a toll on stock market which went on a brief downside mode. And as 10 year yields fell, the S&P 500 took off.

Lessons of History

As pointed out in last week, we can get some clues from history since cycles are products of people’s short memory.

As English writer Aldous Huxley once wrote in the “Case of Voluntary Ignorance in Collected Essays (1959)”

Most human beings have an almost infinite capacity for taking things for granted. That men do not learn very much from the lessons of history is the most important of all the lessons of history.

Today is different from the past.

Global debt levels are at unprecedented scale and continues to compound. G-4 central bank expansion of balance sheets has gone way past $10 trillion as central bankers turn dovish in the face of rising yields.

Just last week, Mario Draghi, the president of the European Central Bank tossed out his non-committal stance and declared that interest rates would “remain at present or lower levels for an extended period of time” and further signalled a “downward bias” in interest rate. 

Meanwhile, Mark J. Carney’s inaugural act, as governor of the Bank of England was to introduced a supposedly new tool called “forward guidance”. And in an official statement Mr. Carney declared that “any expectations that interest rates would rise soon from their current record low level were misguided”[14]

And like Pavlov’s drooling dogs, steroid starved markets swung heavily to the upside…until the US jobs reports, which offset much of the earlier gains.

In the past, it took a few months for central bankers to weave their magic in tempering bond yields. Now the honeymoon seems to take just a day. UK (left), French (middle) and German (right) 10 Year yield soar along with US yields even as the ECB and BoE says that interest rates are bound to go lower.

The bond vigilantes appear to be in open defiance against central bankers!

One can see how Friday’s bond market rout has affected Europe and the US[15]. Since Europe’s market closed earlier than the US, my guess is that selling pressures in Europe has been subdued as US yields soared at the close of the trading session.

If Asia should carryover the bond market carnage, then it is likely that the meltdown should persist in Europe.

Nevertheless given the oversold conditions a temporary pullback should be expected.

Notice too how bond yields in all American and European has surged strongly over a month.

The lessons of history are that rising yields have largely been incompatible with sustained stock market booms. Both may concomitantly rise but the eventual outcome has been a bear market cycle (2007-2008, dotcom bubble), stock market crash (1987) or a quasi-bear markets (1983-1984 or 1981-1982).

The relationship has hardly been statistical but causal—rising rates eventually prick unsustainable debt financed bubbles.

Yet a stock market boom can be engineered by governments that could destroy historical precedents. Venezuela should be an example. Venezuela’s stock market has been up a stratospheric 160% year to date. This translates to star bound 460% in one and a half years. But Venezuela’s deceiving outperformance comes at a heavy toll: the collapse of her currency the Bolivar which means rising stocks are symptoms of hyperinflation.

Again rioting bond markets as expressed through rising yields (which are indicative of higher policy rates) seems like the proverbial ‘sword of Damocles’[16] which hangs over the heads of the stock markets.

Differently put, unless bond markets stabilize, rising stock markets in the US or elsewhere, looks like an accident waiting to happen.

Risk is high.

Trade with utmost caution.

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[1] See Phisix Meltdown: A Reality Check on the Bullish Dogma June 10, 2013

[2] Yahoo.com Major World Indices

[3] Doug Short NYSE Margin Debt: Was April a Cyclical Peak? June 28, 2013

[4] Businessinsider.com Stock Buyback Announcements Have Gone Parabolic, May 29, 2013

[5] See How Tax Distortions Contribute to the Boom Bust Cycles May 2, 2013

[6] Wikipedia.org Dot-com bubble

[7] Wikipedia.org Black Monday (1987)

[8] Wikipedia.org Alan Greenspan Chairman of the Federal Reserve

[9] Wikipedia.org Greenspan put

[10] Mark Carlson A Brief History of the 1987 Stock Market Crash Board of Finance and economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, November 2006. Pointer from Zero Hedge

[11] Edwin M. Truman The Mexican Peso Crisis: Implications for International Finance US Federal Reserve 1996

[12] New York Times ORANGE COUNTY'S BANKRUPTCY: THE OVERVIEW; Orange County Crisis Jolts Bond Market December 18, 1994

[13] Wikipedia.org Savings and loan crisis

[14] New York Times 2 Central Banks Promise to Keep Rates Low July 4, 2013

[15] Bloomberg, Rates & Bonds

[16] Wikipedia.org Sword of Damocles

Bankers Warn US Federal Reserve of Bubbles in Farmlands and Student Loans, More Signs of US Asset Bubbles

Aside from record high stock markets underpinned by exploding net margin debt, there are many side-effects from the Fed’s bubble blowing policies.

Bankers themselves are now warning the US Federal Reserve of asset bubbles evident in farmland and in student loans

From Bloomberg:

A Federal Reserve (TREFTOTL) panel of bankers warned policy makers in February that record stimulus was pushing financial institutions to take on more credit risk and creating a “bubble” in the price of U.S. farmland.

“The margin pressures that the low-rate environment has put on financial institutions, coupled with dramatically increased compliance and other infrastructure costs, have caused many to seek higher returns by accepting greater interest-rate or credit risk,” the bankers said on Feb. 8, following a Federal Open Market Committee meeting on Jan. 29-30.

the farmland bubble chart courtesy of the Zero Hedge

More on the farmland bubble

The panel also said in February that farmland valuations posed an asset-price bubble caused by unusually low interest rates, echoing concerns expressed by Kansas City Fed President Esther George.

“Agricultural land prices are veering further from what makes sense,” according to minutes of the council’s Feb. 8 gathering. “Members believe the run-up in agriculture land prices is a bubble resulting from persistently low interest rates.”

The Fed pledged to hold the benchmark interest rate at zero until the unemployment rate falls to 6.5 percent, as long as inflation expectations don’t exceed 2.5 percent. The U.S. central bank has also engaged in three rounds of bond purchases, known as quantitative easing.

Data compiled by the regional Fed banks have documented a rapid run-up in farmland prices, particularly across the Midwest’s Corn Belt. The Kansas City Fed said irrigated cropland in its district rose 30 percent during 2012, while the Chicago Fed reported a 16 percent increase.

The panel of bankers is appointed by regional Fed banks and dates to the founding of the central bank in 1913. Bloomberg obtained minutes from the quarterly meetings from May 2011 until February.

Student loan bubble chart from the Zero Hedge

Now the student loan bubble

At a meeting in February 2012, the council said “growth in student-loan debt, to nearly $1 trillion, now exceeds credit-card outstandings and has parallels to the housing crisis.”

Student lending shares features of the housing crisis including “significant growth of subsidized lending in pursuit of a social good,” in this case higher education instead of expanded home ownership, the council said.

Bubbles have been ballooning in many areas.

Corporate bonds has likewise been exploding.

From another Bloomberg article:

Sales of bonds from the U.S. to Europe and Asia exceeded 2012’s pace after offerings surged this month to at least $318 billion, compared with $205.3 billion in the similar period last year, Bloomberg data show. Issuance lagged last year’s pace during the first quarter, falling 7.6 percent behind a record $1.174 trillion in the first three months of 2012.

A lot of these bond issuance have been used as vehicles to buyback on stocks in response to tax policies and the cheap money environment that has led to the record levels.

This is why both the US bond markets and stock markets are becoming intertwined.

And more signs of the tightening relationship between stock market and bonds: the bond fund hybrids

From the Wall Street Journal

The number of bond funds that own stocks has surged to its highest point in at least 18 years, another sign that typically conservative investors are taking bigger risks to boost returns.

Regulators generally allow funds to hold a mix of assets, but the scale of bond funds' shift into stocks is unusual, fund experts said, and could expose investors to unexpected losses.

In all, 352 mutual funds that are classified by Morningstar Inc. as bond funds held stocks as of their last reporting date, up from 312 at the end of 2012 and 283 in the first quarter of 2012, according to the investment-research firm.

The rush into stocks illustrates the dilemma bond investors face. The bond market has rallied for much of the last 30 years, and yields, which move in the opposite direction of prices, stand near record lows.

Tightening interdependence of stocks and bonds makes both asset classes equally vulnerable to market shocks.

The deepening of inflationary boom has led credit swaps falling into 5 year lows which are signs of increasing complacency.

Collateralized debt obligations (CDOs) “bad boys of the financial crisis of 2008” according to the Wharton Knowledge, have also been making coming back.

There are many more signs of bubbles being blown. So it would be naïve or downright silly to suggest or proclaim that there has been “no-side effects” from Fed Policies.

Remember inflationary booms leads to deflationary bust. And a bust will likely spur the US Federal Reserve to double or more the $85 billion a month in bond purchases which may expand to include other assets. 

All these means two things: more bubbles or a currency collapse.

How Tax Distortions Contribute to the Boom Bust Cycles

I recently posted about the glaring disconnect between stock market pricing and earnings expectations in the US. 

Aside from the US Federal Reserve’s easing policies and from the implicit guarantees also from the same agency, there is another very significant factor that adds to the serial blowing of asset bubbles: massive distortions from a tax regime which promotes share buybacks financed by leverage.

Philip Coggan under the pen name Buttonwood at the Economist articulates Apple as an example

WHAT a crazy world. Apple, a company with $145 billion of cash, is issuing some $17 billion of debt to buy back its own shares. Why doesn't it just use its cash to do the same thing? First, because a lot of that cash is overseas, and bringing it back to America would incur a tax charge. Second, because interest rates are low and debt interest is tax-deductible, making this look a great arbitrage.

But think of it from the point of view of the hard-working American taxpayer. Apple's money will still sit overseas and not be invested at home to create jobs. Apple's tax bill will fall, as it offsets the interest payments against its profits. The buy-back will probably push up the share price in the short term*, boosting the value of executive options; profits from those options will probably be taxed at the long-term capital gains tax rate of 15%, lower than the rate many workers pay. Organising a bond issue, rather than using a company's own cash, incurs costs in the form of fees to bankers on Wall Street; the same bankers taxpayers helped support five years ago

In short, the incumbent complex tax structure basically rewards debt accumulation and the principal-agent problem.

The latter or conflict of interest dilemma means that the same tax policies induces a fissure between the economic interests of the shareholders and of the option holders, held mostly by corporate officers.  Such has mostly been channeled through the tilting of the balance of incentives that encourages short term outlook and actions at the expense of the long term.

Buybacks and dividend issuance has accounted for a substantial share of the gains in the S&P.

Dr. Ed Yardeni notes that both has totaled “$2.1 trillion for the S&P 500 since stock prices bottomed during Q1-2009 through Q4-2012--has been driving the bull market since it began”.

Yet the distortions from tax incentives that promotes debt funded buybacks has not only been a bane via a conflict interest in corporate relationships particularly between between shareholders and corporate managers, but has also been materially affecting the real economy through the diversion of resources to speculation rather than to investments.

Notes analyst Martin Spring in his latest outlook (no link)

One reason why prices continue to rise despite sluggish growth in corporate profits is the contractionary impact on supply from share buybacks, which are rising towards to levels last seen in 2007.

“The motivation,” reports CLSA Asia-Pacific’s Christopher Wood, “appears to be primarily to boost earnings per share – a formula on which so many corporate executives’ remuneration is based.”

He adds: “The pick-up in commercial and industrial lending in America over the past two years has been primarily driven by the desire to finance financial engineering exercises such as share buybacks, rather than to fund new investment.”

Essentially, the money bubble is being used primarily for speculation rather than stimulating economic activity, its supposed intention.

Government policies whether via taxes or central bank policies or administrative policies (e.g. homeownership) have all been synched or engineered to promote leveraging and debt accumulation.  

Debt is the essence of the paper money system.

Since the world’s monetary system shifted away from the gold standard, debt has increasingly been a tool to promote statistical “growth”.

Thus the increasing recourse to debt also means the increasing frequency of financial-banking crises.

Going back on how tax distortions promote systemic fragility, again Mr. Coggan

In short, the whole deal is linked to tax distortions; the treatment of repatriated cash, debt versus equity and capital gains versus income. The ideal tax system, as we have argued many times, is neutral between sources of income. The tax deductibility of interest played its part in creating this mess, both in the corporate and mortgage markets. Why should the taxpayer want to encourage higher leverage, when high leverage is the root of financial crises?

Well, the answer to that is that debt or leverage mainly works to the interest of the banking-welfare warfare state-central banking cartel, who use debt to finance their intertwined interests. The incumbent political architecture in turn gives voters and taxpayers access to debt, via the above policies. Thus, the boom bust cycles.

That which is unsustainable, won’t last.