Is the Bond Market Showing Confidence These Days?

Barron’s publishes a ratio that it calls a “Confidence Index.”  The Confidence Index is derived by dividing Barron’s index of Best Grade (corporate) Bonds by Barron’s index of Intermediate Grade (corporate) Bonds.

According to this paper, if the intermediate grade index falls relative to the best grade index it represents a sign of market confidence because the intermediate grade bonds are not requiring as much of a yield spread as in the past and this means that investors are more confident.  The paper suggests that this “generally indicates rising confidence, pointing to higher stocks.”

Well, Barron’s Confidence Index hit a near term low in the week ending July 27 and has been rising since.  The implication of this movement is that, potentially, the stock market should rise.

Note: One can use the yields on Moody’s Aaa- and-Baa rated industrial bonds published in Federal Reserve release H.15 and get a similar result.  

Since August 3 the Standard & Poor’s 500 Index has risen about 2 percent from 1390 to 1418.

Defining the confidence index in this way makes some sense since when financial market conditions are improving the yield on intermediate grade bonds tend to fall faster than does the yield on the best grade bonds causing the confidence index to rise. 

Conversely, when confidence is being lost in the bond markets, yields on intermediate grade bonds rise faster than do the yields on the best grade bonds.

This is what happens in a “normal” cyclical situation.

However, the past several months have not been normal.

Barron’s Confidence Index has been rising because the yield on the Best Grade Bonds has been rising relatively more rapidly than the yield on Intermediate Grade Bonds. This is also true of the movement in the yields on Moody’s Aaa- and Baa-rated bonds.

This is not the way it is supposed to be. 

The difference is the fact that the United States bond markets have been a “safe haven” for funds from around the world.  The flow of funds into United States markets have distorted interest rate relationships.

The question is…does this distort the interpretation one gives to Barron’s Confidence Index?

The international money really started pouring into the United States in early May.  The yield on the 10-year Treasury issue broke 1.90 percent on May 8.  Barron’s confidence index reached a near term high in the week ending May 25.  Moody’s numbers actually achieved the near term high in the week ending May 5.  Both measures of “confidence” fell until the week ending July 27 as mentioned above.

In this case, the confidence index fell because of all the foreign money flowing into the United States to seek the “safe haven”.  Yields on US Treasury securities fell very rapidly, but also the best grade of corporate bonds also gathered in some of these funds and the yields on the best grade of bonds fell relative to the yields on intermediate grade bonds.

Confidence in the United States bond market was increasing while Barron’s Confidence Index was showing a loss in market confidence. 

The stock market dropped off soon after this “fall in confidence” with the S&P 500 index dropping off from about 1360 on May 8 and reaching a trough of approximately 1280 at the end of May.  However, as related earlier, the S&P 500 was around 1390 by the first part of August, a rise of slightly more than 8.5 percent.  The rise from May 8 to August 3 was a little more than 2 percent. 

The argument for the immediate decline in the stock market in May was the fear connected with the deteriorating situation in Europe.  After the initial decline in the stock market, “confidence” in the US stock market seemingly came back…although the variation in stock market movements seemed to be rather high indicating the uncertainty connected with what was happening in Europe.

So, when Barron’s Confidence Index dropped off in May the stock market also fell.  From the end of May through the end of July, Barron’s Confidence Index continued to fall while the stock market rose.  So, we have some conflict here.

Another ratio using similar data can also be used in situations like this.  It is called the “Liquidity Ratio” calculated by dividing the yield on 10-year US Treasury bonds by the yield on Moody’s Aaa industrial bonds.  A higher ratio is shows that the financial markets are “more liquid” since the ratio of yields is narrower…funds are getting into the Aaa market as well as into the government market.   

The “liquidity ratio” peaked out this year in the same week as did the “confidence index” using Moody’s numbers.

However, the “liquidity ratio” hit a bottom around the same time that the S&P 500 index was hitting the near term bottom in late May.  This would indicate that some of the “safe haven” funds coming into the Treasury market began to spill over into the high grade corporate bond market…the financial markets were becoming “more liquid” due to the funds attempting to achieve higher yields without much loss of quality. 

Thus, the stock market began to rise again in June as confidence rose on the “liquidity” of the financial markets, even though the liquidity had not flowed as far as the intermediate grade instruments. 

It was not until late July that more and more funds moved into Baa or intermediated grade bonds and Barron’s Confidence Index started to rise again…along with Moody’s numbers. 

The “liquidity ratio continued to rise through to the present so that for the last several weeks we have had both the “confidence index” and the “liquidity index” giving off similar signs. 

Note, however, that the yield on the 10-year Treasury yield has been rising over the same time period, reaching its lowest level on July 25…1.43 percent.  Currently, the 10-year Treasury is yielding over 1.80 percent. 

The last several months, therefore, have been an interesting time period.  The movement of international funds into the United States has caused some financial market relationships to be distorted.

Still, it is important to work with the data and see if events can be explained by including more information in one’s analysis.  Historically, the “confidence index” information has moved in the same direction as the “liquidity index” information.  When they differ it is important to try and reconcile why they might be moving in different directions.  In the current situation, I believe that looking at the two ratios helps us to understand a little bit better what has been going on. 

Right now, the bond markets are reflecting market confidence and market liquidity, both of which are positive signs for a rising stock market. 

The US Bond Market and the Situation in the Eurozone

In my last post, I wrote about the bond market in the United States and how the European situation is impacting the structure of yields in US financial markets.  My conclusion was that the “flight to quality” being experienced in world financial markets has led to a situation in which the supply of funds to United States financial markets has resulted is extremely low long-term interest rates and a negative yield on the US Treasuries inflation-adjusted securities (TIPS). (http://seekingalpha.com/article/551121-what-are-the-bond-markets-trying-to-tell-us) 

The question then becomes, if the extremely low long-term interest rates are a consequence of a “flight” of funds from European markets and this condition will last in some form until the European Union “gets it act in order” what will be a condition of Europe “getting its act in order”?

Over the past two years or so the efforts of the European Union to resolve the sovereign debt crisis has “kindly” been referred to as “kicking the can down the road.”  No one seemingly wants to “get their hands around the situation” and work to resolve the crisis.  Consequently, the crisis lingers on with recurrent bouts of national concern like that now being focused on Spain. 

It should be obvious by now that “kicking the can down the road” is not going to end the sovereign debt crisis in Europe. 

The current direction in which European elections are headed seems, if anything, a step backward in the process.  But, Europeans are tired of all the austerity.  They want to throw existing policymakers out of office and elect someone else…it doesn’t really seem to matter who.  And, we are seeing this played out in this weekend’s elections in France and Greece.  This following the situation in the Netherlands where the existing government was defeated, the 10^th such government to lose power since the debt crisis began.  

Tom Sargent, an economist who won the Nobel Prize last year, suggested in his Nobel Prize winning acceptance speech that the current problems being faced by the nations of the eurozone are similar to those faced by the United States as it was trying to become a unified country in the late 18^th century.  The European Union now is like the US under the Articles of Confederation at that time.  The US had to become a unified country under a Constitution and establish its fiscal credibility before it could operate as a nation among the other nations of the world.  Sargent suggests that Europe must achieve the same goal. (http://www.nobelprize.org/nobel_prizes/economics/laureates/2011/sargent-lecture.html)

While the fiscal crises of the states was going on during this period in the United States there was also a banking crisis going on in the private sector, a lot of it caused by the credit problems faced by the states.

Taking the experience of the United States as an example, one can argue that the only way the European Union is going to “get its arms around the problems” is to form a fiscal union amongst it members that will supplement the monetary union that is already in existence. Many anticipated this next step when the original monetary union was formed. (http://www.ft.com/intl/cms/s/0/50a1f9fe-9466-11e1-8e90-00144feab49a.html#axzz1tp5ngu6K)

However, the fiscal union implies more.  A federal union of countries is going to have to establish its credit standing in the world which means that it will have to be able to issue debt with the “joint and several liability” of the eurozone backing it.  Of course, this implies that the new fiscal union of eurozone countries will conduct it budget operations on a sound basis. 

Furthermore, the eurozone is going to have to move to save European banks.  The European Central Bank cannot solve the whole problem through its “liquidity” efforts.  The countries of the European Union are going to have to provide funds directly to the European banks that need them.  This will not be inexpensive in the short-run.  Hopefully, over the longer run the European Union will get a large portion of the funds back.

European banks are even in worse shape that United States banks.  Bloomberg Markets magazine has just released its list of the strongest banks in the world.  There are only four European banks in the top twenty: two from Sweden, one from the U.K. and one from Switzerland. (http://www.bloomberg.com/news/2012-05-02/canadians-dominate-world-s-10-strongest-banks.html)

Whoops!  None of those banks are in countries in the European Union.  Seems like the strongest banks in the world are not in countries that have pursued the policies of credit inflation that have created huge amounts of debt.

The problem is: who is going to lead Europe into a fiscal union?

Angela Merkel, the German Chancellor, has indicated that that is the direction in which she is headed.  Yet, it is not altogether clear that the German people will accept a fiscal union because so much of the load of the new union will be placed on Germany.  Furthermore, you have the move to new governments within the European Union that “anti-austerity” and “anti-German.”

Still, Germans have benefitted more than any country in Europe from the monetary union and from its reunification and from integration with other European countries.  Germany stands to continue to benefit from “more Europe” rather than less. 

And, this is true of the rest of Europe.  It is not an easy path to a new European future, a united Europe, but it will, in the end, produce the greatest amount of wealth and prosperity for the continent as a whole. 

This is a massive undertaking.  A movement in this direction will not resolve all of Europe’s growth problems, its unemployment problems, or, its real estate problems in the near term.  To stay separate, however, in my mind, is almost unthinkable.  We might get a taste of this soon in Greece if a new government comes to power that cannot follow up on the conditions of the recent bailout.  If the new government is unable to deliver, the European Union may ask for it to withdraw.  My sense is that this would be pretty bad.

In terms of the United States bond market, I believe that it will not take the full consolidation of the European fiscal union to reverse the flow of funds coming into US financial markets.  What is needed, however, is some credible leadership to arise in Europe that can achieve some credible gains in movement toward the union.  Given the elections coming up this weekend and in the near term, it is hard to see such leadership ascending.  So, it may be awhile before yield relationships return to more normal levels.        

What Are the Bond Markets Trying to Tell Us?

What are investors in the bond markets trying to tell us?  To me, we must give some kind of interpretation to where current yields are in order to get some idea about where financial markets believe that the economy is going.

Historically, one could take an estimate for the expected real rate of interest and add to this one’s expectation for inflation and come up with a projection for what the nominal rate of interest on United States Treasury should be. 

In today’s environment this is problematic.  In the past a good proxy for the expected real rate of interest was the expected long-term growth rate of the economy. (Equating the expected real rate of interest with the expected long-term growth rate of the economy has the backing of the accepted economic growth theory and has worked on a practical basis.)

Whereas in the past one could estimate the expected real rate of interest at around 3.00 percent since the expected long-run rate of growth of the economy could be around this number. 

Being a little more conservative let’s say that the expected real rate of growth of the economy in the near term will be around 2.25 percent. (http://seekingalpha.com/article/503181-economic-growth-will-continue-entering-the-next-stage) Given the rule presented above this means that we could expect that the real rate of interest in the economy should be around 2.25 percent.

Now, the current year-over-year rate of increase in the GDP implicit price deflator is 2.1 percent.  Again, to be conservative, let’s assume that our expected rate of inflation is just 2.0 percent.

This would mean that our estimate for the yield on the 10-year US Treasury bond would be 4.25 percent even given our very conservative estimates of the real rate of interest and inflationary expectations. 

This forecast is problematic because the current yield on the 10-year US Treasury bond is around 2.00 percent. 

 The problem that we are dealing with at the present time is that the United States is experiencing an inflow of funds from the rest of the world due to a “flight to quality” coming from the continent of Europe.  In this “flight to quality” investors are not looking at earning a sufficient amount of return to earn themselves an inflation protected real rate of interest.  These investors are looking primarily for a “safe haven” in which to place their funds and earn something more than they would earn keeping their funds in cash or very short-term securities. (http://seekingalpha.com/article/507891-u-s-treasuries-still-a-safe-haven-and-yields-on-tips-remain-negative)

 

This “flight-to-quality” has driven the yield on the 10-year US Treasury security to around 2.00 percent.  This “flight” is the dominating force in the bond market these days.

This “flight” is even dominating whatever the Federal Reserve is doing these days.  The interpretation here is that the supply of funds coming into the US market is keeping these interest rates so low allowing the Fed to do next to nothing in keeping US interest rates so low.  (http://seekingalpha.com/article/519961-don-t-expect-qe3-from-the-fed-this-week) This, of course, is taking some of the pressure off Fed Chairman Ben Bernanke. (http://seekingalpha.com/article/542361-economic-growth-for-the-first-quarter-good-scenario-for-bernanke)

Bond holders, however, want to be protected from the deterioration of the real value of their bonds so they are still asking for protection against the inflation they expect to face in the future.  That is why the yield on 10-year inflation-protected Treasury issues (TIPS) have been paying a negative yield.  This negative yield is around 0.30 percent. 

Thus, if one subtracts the yield on TIPS from the yield on the 10-year issue from the yield on the 10-year Treasury bond, one comes up with the market’s current estimate for future inflation.  At this time expected inflation is around 2.30 percent, a little above the current rate of inflation cited above. 

Note that the yield on TIPS became negative in early August 2011, when the European sovereign debt crisis picked up once again specifically relating to the events in Greece.  The concerns over Europe continue with the emphasis now shifted to Spain.       

In terms of the future, I would argue that the negative yield on TIPS bonds will not become positive again until the European situations eases enough so that funds will start returning to “riskier” debt in Spain, and Portugal, and Greece, and Italy.  As these funds begin to flow out of the US Treasury market, yields will begin to rise and historical relationships will return. 

What I am saying here is that if TIPS rise to around 1.00 percent, the level of earlier 2011 as seen in the accompanying chart, and inflationary expectations remain at even 2.00 percent, the yield on the 10-year Treasury issue should rise to at least 3.00 percent. 

If the economy continues to grow at a rate in excess of 2.00 percent and inflationary expectations remain at the 2.00 percent level, the yield on the 10-year Treasury issue should rise to at least 4.00 percent.

The European debt crisis is having a major impact on US bond markets and yield relationships and will continue to do so until European officials really resolve their fiscal problems.  Thus, look for what happens to the yield on TIPS in the near future.  That will provide information on what the financial markets think about European prospects.

Given this scenario, the next pressure point for the Federal Reserve will occur when the Europeans do resolve their financial issues.  Then the Federal Reserve will be faced with having to deal with rising interest rates and this will make its life just that much harder.