Monday, December 21, 2015

Bonds and Stocks

When I read the headline, I thought the article would be about the difficulty of finding a return in the current low yield environment. It turns out its on something completely different (excerpt):
In search of higher yields

THE correlation between yields and stock markets are clear to see. When yields are high, stock markets are down. When yields are down, money pours into the stock market, and hence it goes up (see chart).

From the chart, it is obvious that since the Fed launched quantitative easing in 2009, rates have sunk to all time lows – close to zero. Meanwhile stock markets start rising when money is in search of yield and growth. Thus when yields are low, the stock market moves up. 

An interesting observation from the chart is the huge gap between rates and the stock market from 1985 to 1993. 

In 1985, the US Treasury 5-year notes were offering yields of above 10%. Not surprisingly, investors would gladly take their money out of the markets and put it in treasury notes or bonds, which are almost risk free. 

Now, as the yields started to drop, notice how the stock market starts inching up. This is because investors start to realise that bonds can no longer give them the best yields, and thus they shift their money into the stock market. 

From 1993 to 2006, yields on the 5-year note and the stock market moved almost in tandem. 

Over that period, the yields moved in a band of between 4% to 6%. At this level, bond yields and stock market returns are about equal. So investors are interchanging; when yields go closer to 4%, they shift their assets into the stock market. Then when yields move up again, they shift back out of equity markets and into treasury notes….
So, what’s the problem (yes, there’s more than one)?

Start with the basics of bonds – bond yields are the inverse of their prices. Let me repeat that in English – when yields are high, bond prices are low, and when yields are low, bond prices are high. Prices are low (yields are high) when demand is low, and prices turn higher (yields fall) when demand is higher.

You should immediately see the problem with the article’s narrative – it has the causality precisely backward. Low yields are caused by high demand for bonds; high yields occur when investors demand higher compensation to hold bonds i.e. demand is low. The article takes yields as given, not a variable that is also subject to supply and demand (and I haven’t even brought in the supply side here).

If you take the purported correlation shown in the chart as evidence some form of causal relationship, then the correct interpretation should be that investors are buying both stocks and bonds at the same time, or selling both at the same time.

Second, from my recollection, there have been 3 Fed rate cycles in the period covered by the chart. I can sort of detect when they occur in the chart data, but they don’t override the down trend in the Treasury yield. This has been noted by other researchers before: interest rates globally have been in secular decline. In English – interest rates and bond yields have been slowly declining over the past thirty years independently of everything else. The reasons put forward as to why are varied, from a global savings glut to a reduction in inflation expectations, but suffice to say it has little to do with investors shifting from bonds to stocks, or vice versa.

Third, from a technical standpoint, you can only infer causality if you’re comparing like to like. The chart shows the level of the KLCI versus the yield on 5 year Treasuries. This is totally wrong. What should be used is either the level of the KLCI versus the price of Treasuries; or the return on the KLCI versus the Treasury yield. The former will show the price of Treasuries gradually creeping up as the KLCI goes up, while the latter will show the return on the KLCI gradually declining even as Treasury yields have declined. This leads us to the same conclusion as point 1 above: investors are buying or selling stocks and bonds at the same time, not switching from one to the other.

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