Is the bond market smarter than the stock market? Photo / 123RF
COMMENT:
Is the bond market smarter than the stock market? Many investment professionals seem to think so.
Markets guru Jeremy Grantham, from fund manager GMO, once compared the stock market to a brontosaurus. It takes a long time for a pain message from a bitten tail to travel up the spine, one vertebra at a time, to the head.
Grantham was talking about the credit crunch preceding the global financial crisis and the pain signal was shrinking credit availability.
The delayed reaction, as might be expected from a lumbering behemoth, was of course spectacularly destructive.
This metaphor has been extended recently by observers looking at the reactions of the bond and equity markets to speeches by US Federal Reserve chairman Jay Powell. For example, in October last year.
Bond markets fell instantly on Powell's October comment that interest rates were "well below" the neutral rate. Stocks did nothing until crashing a week later.
This sequence of reactions is useful in two related ways.
First, from a very near-term perspective, bond market moves can be good early warnings of how the stock market is likely to react to news.
Second, and more importantly, is the fact that the bond market is often regarded as a more useful indicator of future economic conditions than the stock market.
The reason is that when you invest in a bond, you choose a yield and a term.
You can buy bonds with short durations or long (a decade or even longer). This decision means you are forming a view about what the economy will be like when your bond expires, what that means for interest rates, and therefore what return you think is acceptable from the bond.
For shorter-term bonds, this is reasonably straightforward. Your view, and everyone else's, will rely on where the relevant central bank has set interest rates. For example, the official cash rate in New Zealand.
It also means investment decisions for shorter-term bonds are less speculative than a short-term investment in equities or commodities. This lower level of speculation in bond investments is a big part of the argument for bonds being smarter than stocks.
But what the OCR (or the Federal funds rate in the United States) is now, is not so reliable for estimating what policy decisions on interest rates will be in two years, or five or more.
So for longer-term bonds, you're making an educated guess about where economic conditions will be. Because of this, the yields on longer-term bonds tend to be more volatile.
Generally, longer-term bonds command higher interest rates, because investors want higher yields to compensate for the risk of holding a bond for longer.
But when expectations about future economic growth are glum, the gap between the expected interest rates for short and longer-term bonds narrows.
Sometimes it even reverses, so investors expect a better return in the short-term than in the long-term.
This particularly gloomy outlook is called yield-curve inversion (because the typical curve, with interest rates moving upwards from short duration to long duration bonds, is effectively upside down) and is regarded as a historically accurate warning of an approaching economic recession.
This is topical, as the curve inverted earlier this month, for the first time since July 2007 (with recession following in December 2007 and the global financial crisis in 2008 and 2009).
The stock market hasn't plummeted as a result, but studies of inversion over long periods (since the 1929 recession), show the S&P500 index typically continues to gain by a median of 21 per cent after inversion is hit. The brontosaurus keeps trundling along.
Plus, recession takes a median 19 months to occur after inversion, and doesn't follow every time inversion occurs.
Market observers are deep in hot debate about what the inverted yield curve means, or doesn't, for the global economy.
Some are questioning whether the yield curve has lost its power as a canary in the coalmine for coming recessions.
But no one is querying the fundamental usefulness of bond markets as an indicator of collective confidence about economic conditions in the next six to 12 months.
It's inevitable the brontosaurus will react. But will it just flinch? Or will we have another stampede?
- Mike Taylor is founder and CEO of Pie Funds.