Ban The Bond

The worst 3-month bond market performance in 40 years has investors wondering if the nature of risk changed. Now that we have flipped the usual relationship of which asset is riskier on its head, are we seeing a serious regime change in the capital markets? Are bonds in a no-fly zone?

And forget what you were taught about the risk premium on equities. There is nothing inviolate about that relationship given its long and varied history. The Fed, in its attempt to master the universe and make private risk into a public good, has seen to that. By distorting the transfer mechanism of the economy to the financial markets this is what you get. The relationship between bonds and stocks is again being redefined as we speak.

What investors should expect and what they get are often two different things. In the classical economic construct, Professor Markov taught us that the more volatile asset generates a commensurately higher return. But bonds are making the case for the top spot in the risk spectrum now that inflation concerns have suddenly accelerated. It's no wonder that the equity markets have shrugged off the latest series of threats. The hawkish pivot by the Fed and worsening growth expectations due to covid, oil, and war have been neutralized by a sudden shift in risk tolerance by investors. They bought the dip, not despite higher yields but because of them.

Massive fund flows especially in a suddenly illiquid market sent relative return seekers scurrying to their terminals to rebalance portfolios into equities from bonds. In a self-fulfilling outcome, stocks are dramatically outperforming fixed income because of the risk aversion to inflation. And there is still room left in that trade. Sorry bears, TINA has only gotten more confident since the bond market became suddenly uninvestable.

The chart below, courtesy John Aitkens of TD Securities shows the long-term history of the relative yields on equities and bonds in the U.S. market over the past 80+ years (below). When the blue line is above the red line, equities are priced 'cheap' to bonds. We can see two distinct phases: the 1940 to 1980 period of rising yields, and the subsequent secular decline experienced since the peak.

A post-WW2 relative attractiveness spike produced a sustained equity bull market that lasted until the late 60's. The inflationary 70's produced generally muted equity returns and culminated in another generational spike in relative attractiveness in 1980-82.

Although interrupted by a crash in '87 and a recession in '91, stocks generated strong returns during the extended deflationary period of 'disinflation' and the secular decline in yields during the '80s and '90s.

The resultant bull market in fixed income drove equity valuations to a breaking point in the Tech Bubble period in 2000. Relative valuations dramatically 'mean-reverted' in the subsequent 'Tech Wreck" and stocks quickly became attractive.

The subsequent China/Real Estate driven rally of the 2000's again flamed out dramatically during the 'GFC' and equities became generationally 'cheap' again. (Does anybody remember my 2009 quote: "Martians with Ray-guns"?)

We are still unwinding the relative attractiveness of equities from that low point, despite the extended appearance of the stock market. Even a pandemic was just a minor blip as fixed-income yields plummeted faster than equities reinforcing the case for equities. The subsequent rebound in equity prices, while spectacular, has yet to generate a complete closing of the 'attractiveness advantage' of equities over bonds. It just shows how 'expensive' fixed income assets had become during the great monetary experiment called "QE".

Stock Earnings Yield & Bond Yields 1940-2022

So if one anticipates a prolonged rise in interest rates over the next decade, one can also anticipate a step-wise decline in the equity risk premium. Investors' preference for equities, rather than declining due to the geopolitical and monetary risks, has actually increased as a result of the inflation scare. Until we reach a breaking point for the economy that damages earnings, or conversely the Fed raises interest rates sufficiently to compensate bonds for their loss of purchasing power, we should expect the market to be resilient. The metaphor of choice would be 'pushing a beach ball under water'.

At some future point, there will be a reckoning to be had, but for now, stocks are the cleanest shirt in a very dirty laundry basket. The latest reading of the relative attractiveness chart is shown below. If this was a stock, I'd sell it. It's going to zero.

Equity Risk Premium Proxy

Risk Model: 4/5 - Risk On

Although over-bought, equities are again finding favour with risk-takers. The AAII sentiment indicator turned up dramatically last week, reinforcing the notion that stocks are, again, the only game in town. It's no wonder that hard asset themes are dominating the selection, given the supply-shock-driven spikes seen in almost all commodities. Lumber ( see Homebuilders, $XHB) is one of the few losers, reflecting the rate hike environment and the domestically insulated supply chain. Notable weakness in Transports, Financials, and Semis do give off a whiff of recession fears, though. The flatness of the yield curve has also raised a red flag. Only the massively steep 3 Month - 2 Yr part of the curve remains between us and a Fed engineered recession (chart below). There is still a long way to go. Sorry but 'stay tuned' is all I can offer.

3 Month T-Bills vs 2Yr Yields

Will the Fed actually have the guts to take this economy to the woodshed for a much-deserved thrashing, or will they, like late 2018, pull their punch at the last minute? The performance of the equity market may have much to say about it. If that's the case - shouldn't we actually root for another pull-back?