Abrupt Normalization in Bond Market (excerpt)

One simple model of the 10-year bond yield compares it to the growth rate of US nominal GDP on a y/y basis. While real GDP fell 0.7% (saar) during Q1 on a q/q basis, it was up 2.7% y/y, confirming that the quarterly result might have been distorted by faulty seasonal adjustments. Recent economic indicators confirm that the US economy continues to grow at a moderate pace. In any event, nominal GDP rose 3.6% y/y during Q1. That’s well above even the latest yield. In the Eurozone, real GDP rose 1.5% (saar) q/q during Q1. It was up 1.0% y/y, with nominal GDP rising 2.0%.

This suggests that the rebound in yields is an abrupt normalization relative to nominal economic activity. This happened in reaction to the ebbing of deflationary fears. Expected inflation in US 10-year TIPS is up from this year’s low of 1.54% on January 13 to 1.86% on Tuesday. In addition, growth prospects seem to be improving in the US and Eurozone. While the ECB is committed to its QE program through most of next year, the Fed is likely to respond by raising the federal funds rate later this year. Expectations that the Fed will soon start normalizing monetary policy is another explanation for the abrupt normalization of bond yields.

Today's Morning Briefing: Bond Bath. (1) Blondes vs. bonds. (2) Bonds vs. bunds. (3) Where do we go from here? (4) From abnormal to less abnormal. (5) Deflation fears ebbing. (6) A simple bond model. (7) Draghi deserves credit and blame. (8) Dudley says Fed policy is market dependent. (9) Tranquility in the commodity pits. (10) Riding the Age Wave. (More for subscribers.)

Central Banks Restore Wealth, Working on Growth (excerpt)

The major central banks of the world have been easing their monetary policies significantly since the financial crisis of 2008. They’ve succeeded in averting another financial crisis so far. They’ve also succeeded in recovering most of the fortunes that were lost during the crisis. For example, the total market value of all stocks traded in the US rose $22.7 trillion since Q1-2009 through the end of last year to $36.5 trillion. The S&P 500’s capitalization has increased $12.9 trillion during the bull market so far through last week. Both are at record highs, with the S&P 500 exceeding its 2007 peak by $5.0 trillion. All equity investors have benefited from the stock market rally.

Bond investors also enjoyed big gains as yields fell and prices rose. For example, US bond mutual funds had capital gains totaling $522 billion since the start of 2009. As we noted yesterday, the 12-month average of the median existing home price is up 29% since February 2012, while real estate held by households has increased by $4.2 trillion since then through the end of last year. Gold has also been golden, with a 118% rise in the price since the start of 2009 to its record high on September 6, 2011. It’s down 36% since then, but that’s hardly a sunken treasure for anyone who bought gold a few years ago.

Nevertheless, the central banks have been frustrated by the slow pace of the recoveries in their economies since the crisis of 2008. Reviving self-sustaining economic growth hasn’t been as easy as easing has been. Previously, I’ve argued that the ultra-easy monetary policies of the central banks might perversely have contributed to the slow pace of economic growth.

Today's Morning Briefing: Easy Come, Easy Go. (1) Elvis Presley and Janet Yellen. (2) Sunken treasures recovered. (3) Why easing hasn’t worked as expected. (4) Stock gains aren’t trickling down. (5) Savers earning less so saving more. (6) Fed has enabled fiscal excesses at cut-rate rates. (7) Near-zero interest rates contributing to income inequality. (8) Fed policies causing capital misallocation. (9) Enabling financial engineering. (10) The blame game. (11) Demography is also a downer. (12) Focus on market-weight-rated S&P 500 Industrials. (More for subscribers.)

How the Fed Depressed the Recovery (excerpt)

In my opinion, the Fed has significantly contributed to the weakness of the current economic expansion as follows:

(1) By keeping interest rates near zero for so long, risk-averse savers have had to accept bupkis for returns on their liquid assets, which rose to a record $10.7 trillion during the week of May 11. Many of them have been saving more, thus spending less. The 12-month sum of personal saving has been running around $700 billion since the end of the financial crisis in 2008, double the pace during the 1990s and the first half of the previous decade.

(2) Ultra-easy money attracted investors rather than nesters into the housing market following the 2008 crisis. They bought up all the cheap homes and drove home prices back up to levels that may be unaffordable for many first-time homebuyers.

(3) As I’ve discussed many times over the past year, thanks to the Fed, corporate bond yields have been trading below the S&P 500’s forward earnings yield since 2004, providing companies with an incentive to buy back their shares and engage in M&A rather than invest in plant and equipment.

Cheap money did stimulate some business investment, but the increased capacity wasn’t matched by more demand, resulting in some deflationary pressures. Stock prices have soared, but this has exacerbated the perception of widespread income and wealth inequality.

Today's Morning Briefing: Tiptoe Through the Soft Patch. (1) Tiny Tim and Janet Yellen. (2) Is the Great Recession over yet? (3) ECI wages get a footnote. (4) Yellen still worrying about underwater homes. (5) Three abating headwinds. (6) Fed sees 2.5% real GDP growth ahead. (7) Yellen is in one-and-done camp. (8) What’s the matter with Kansas? (9) Are the headwinds abating? (10) Here is how the Fed’s policies have depressed consumer and business spending, and housing activity. (11) What’s the matter with the dollar, bonds, and stocks? (More for subscribers.)

Valuation & the Fed Model (excerpt)

Valuation like beauty is in the eye of the beholder. With bond yields at historical lows, why shouldn’t valuation multiples be at historical highs? At 2%, the 10-year Treasury bond yield has an effective forward P/E of 50, implying that stocks trading at a forward earnings yield of 5.9% and a multiple of 17 are grossly undervalued by as much as 62%. Of course, this “Fed Model,” as I first named it back in July 1997, has been showing that stocks are undervalued since the Tech bubble burst. Furthermore, historically low interest rates may be a sign of secular stagnation, which isn’t particularly bullish.

Previously I’ve argued that valuations are being driven by equity purchasers who don’t pay much attention to valuations. They are corporate managers buying back their shares because the forward earnings yields on their shares exceed their borrowing cost of capital in the bond market. As far as they are concerned, beauty is measured by the appreciation of their stock price as they buy back their shares. In this scenario, the source of irrational exuberance is the ultra-cheap money available in the bond market for share buy backs and M&A thanks to the ultra-easy monetary policies of the Fed.

Today's Morning Briefing: Beauty Contest. (1) Episode 42 in The Twilight Zone. (2) Different strokes: Dear Leader vs. King Kong. (3) Some pushback on valuation. (4) Irrational Exuberance Zone. (5) The 3 scenarios again. (6) Channeling the Tech bubble. (7) Record PEG for S&P 500. (8) Smithers & Co. on Tobin’s Q. (9) Does valuation matter? (10) Do interest rates matter? (11) Draghi renews his vows. (12) Front-end loaded QE. (13) Lackluster recovery in Eurozone. (More for subscribers.)

Bond Market: Sprechen Sie Deutsch? (excerpt)

Yesterday’s much weaker than expected US retail sales report initially caused the 10-year US Treasury bond yield to fall in the morning. Then it spent the rest of the day moving higher. The comparable pesky German bond yield continued to move higher to 0.73% from its record low of 0.03% on April 17. The US bond yield has been joined at the hip with the German one all year.

While April’s payroll employment report put a Fed rate hike back on the table yet again for June, the retail sales report arguably took it off the table--yet again. That should have been bullish for bonds. Instead, the dollar took a dive on the soft-patch sales report. The weaker dollar lifted the prices of precious metals and oil (before crude oil inventory data depressed them), which also unnerved bonds.

A 2% bond yield looks attractive for the US 10-year Treasury given the subdued outlook for the Fed’s rate hiking. The problem is that if the German yield gets there, the US yield will be closer to 3%. That would make it even more attractive as long as you didn’t buy the bond at 2%.

Today's Morning Briefing: Consumers Not Registering. (1) Less “ka-ching” around the world. (2) A demographic theory of secular stagnation. (3) Older workers can’t depend on broke social welfare states. (4) May you live a long life and have lots of savings. (5) How governments depressed fertility. (6) US retail sales join the soft-patch batch. (7) China’s senior moment? (8) Japan, Italy, and Germany are at the top of median-age ranking. (9) Spotting some shoppers in Europe. (10) Bonds learning to speak Deutsche. (11) Focus on market-weight-rated S&P 500 Retail industry. (More for subscribers.)

What’s Driving Yields Higher (except)

Only a few weeks ago, we all figured out why bond yields had dropped close to zero in the Eurozone. It was mostly because the ECB implemented QE on March 9, and pledged to buy bonds yielding at least the same as the central bank’s deposit rate, which was lowered to minus 0.20% on September 4.

That hasn’t changed. So why the backup in bond yields? Maybe the markets have concluded that the ECB’s QE will avert deflation and boost the Eurozone’s economic growth. The rebound in oil prices certainly helped to allay some of the deflation concerns in the bond market.

Oil prices stopped falling on January 13. The price of copper stopped falling on January 29, and is up 18% since then. Both have been highly correlated with the US bond yield over the past year. The rebound in the price of oil may be a correction of a severely oversold condition. The supply/demand balance remains bearish, but turmoil in the Middle East is recurring and tends to add a risk premium to the price of oil.

The price of copper may reflect an improving global economy in general and a strengthening Chinese economy in particular. More likely, it reflects expectations that the Chinese government will provide lots of stimulus to revive China’s growth rate, which isn’t likely to happen.

Today's Morning Briefing: Major Tom & the Fed. (1) Ground Control has lost control of the bond market. (2) Bond yields should maintain current altitude for a while. (3) Stocks ready to go into outer space? (4) A simple theory for the backup in yields. (5) Close correlation between bond yield and oil and copper prices over past year. (6) US bond market no longer for isolationists. (7) Four Fed heads speak. (8) No big surprise in Q1 earnings season’s positive surprise. (9) Financials and Health Care sectors save the quarter. (10) Energy earnings crash and burn, but S&P 500 earnings up impressive 11.5% y/y ex-Energy. (More for subscribers.)

Why Are Bonds Taking a Dive? (excerpt)

US bond yields have jumped recently. The 10-year Treasury is up from a recent low of 1.87% on April 17 to 2.26% yesterday. Everyone is blaming that development on the spike in Eurozone bond yields, particularly the surge in the 10-year German government yield from its all-time low of 0.033% on April 17 to 0.58% yesterday. That’s despite the implementation of QE by the ECB starting on March 9.

With the benefit of hindsight, the backup in yields isn’t a surprise. Yields simply fell too low at the start of the year on fears that plunging oil prices might trigger widespread deflation, especially in the Eurozone, and maybe cause another financial crisis if oil companies started to default on their debts. Now that oil prices have rebounded, those concerns are evaporating and yields are normalizing. I think it’s that simple.

In any event, the backup in bond yields is doing the same to mortgage rates in the US. That could stall the already lackluster recovery in the housing industry, which might explain why lumber prices are falling. So maybe the Fed should postpone its lift-off given the lift-off in bond yields?

Today's Morning Briefing: Bonds Away? (1) Confused Fed heads. (2) More on the dark side than the light side. (3) Our collective conundrum. (4) A simple explanation why bond yields have surged. (5) Are bond traders expecting Fed lift-off, while forex players aren’t? (6) Wages might finally be rising faster, but gasoline prices are rising rapidly too. (7) Stocks, bonds, and currencies could be choppy through the summer. (8) FOMC members expecting much better growth may be disappointed. (9) ADP payrolls especially weak for large goods-producing companies. (10) Oil and dollar hitting capital spending on construction and industrial machinery. (11) Focus on overweight-rated S&P 500 Financials. (More for subscribers.)

German Bond Selloff Spills Into US (excerpt)

In recent days, there have been lots of mixed and confusing signals coming out of the Eurozone and US economies, and investors have acted accordingly. On Friday, May Day was a happy day for stock investors as they merrily danced around the maypole. The day before, they all seemed to run for cover. The S&P 500 fell 1.1% on Thursday and rose 1.1% on Friday to 2108.29, just 0.4% below the record high of 2117.60 on April 24. It’s been range-bound since the start of the year.

For bond investors, it was “Mayday! Mayday! Mayday!” every day last week. The 10-year US Treasury yield rose to 2.12% on Friday from 1.93% the week before despite a weaker-than-expected GDP report and a relatively benign FOMC statement on Wednesday.

US yields rose in reaction to the rise in the German government’s 10-year bond yield from this year’s record low of 0.033% on April 17 to 0.37% on Thursday, just before much of continental Europe took Friday off for May Day. Germany’s economic indicators have been showing some strength, and deflationary fears seem to be subsiding. On Thursday, we learned that the Eurozone’s CPI was unchanged during April on a y/y basis as energy prices rebounded. It hit a recent low of -0.6% during January when oil prices were finding a bottom. No one seemed to care that the core CPI rose just 0.6% y/y during April, the same as the month before.

Furthermore, the euro has rebounded from the year’s low of $1.05 on March 13 to $1.12 on Friday, suggesting that Eurozone investors may be losing their interest in US bonds, even though US bonds still yield much more than German bonds. The stronger euro caused the EMU MSCI to sag by 2.8% last week, but rise 0.4% in dollar terms.

Today's Morning Briefing: Mixed Signals. (1) May Day vs. Mayday. (2) Dancing around the maypole. (3) German bond yield backup spills over into US bonds. (4) ECI showing first sign of rising wage pressures. (5) US business surveys were relatively weak in April. (6) CPI vs. PCED. (7) It all depends on FOMC’s interpretation of the data they depend on. (8) Oil exporters selling US Treasuries and other reserves. (9) First day of month often bullish for stocks. (10) Home in the range. (11) Stocks on verge of melt-up? (12) Bonds on verge of meltdown? (13) Signs of life in commodity pits. (14) “Ex Machina” (+). (More for subscribers.)