Bonds yields say beware as equity markets rally rolls on

What do falling bond yields mean for stock markets? Maybe it’s not a question equity investors have spent a lot of time pondering. With stock indexes testing new highs on a regular basis, what is there to worry about?

Well, while the bull market has shown few signs of slowing, stoked by the promise of U.S. fiscal stimulus and an uptick in global growth and corporate earnings, bond markets seem to be raising some yellow flags.

The bond sell-off that started in early July and accelerated with the election of Donald Trump bumped 10-year U.S. Treasury yields by more than 100 basis points to the end of 2016, and they kept climbing through to mid-March. Fixed-income investors saw stronger growth and a more hawkish Federal Reserve as reason to believe rates would rise. The Fed, at least, did not disappoint, hiking in December and then again in March. Everything seemed to be going according to script.

Since then, however, the tide seems to have turned. Bond prices have recovered and yields have fallen. Between March 13 and May 2, 10-year Treasury yields dropped by more than 30 bps. Canada 10-year benchmark bond yields fell by more than 35 bps over the same period, even as the economy turned in stellar annualized GDP growth in January of 2.3 per cent.

So it looks like bond investors are flagging dimmer expectations for growth, for inflation and — let’s be blunt — for Donald Trump. And yet stock markets keep on trucking like there’s no tomorrow, or at least no sign of trouble. Both sides can’t be right, can they?

Certainly, if bond markets are signalling pending disappointment in Trump’s stimulus efforts, they have plenty of reason. On Obamacare, tax reform and infrastructure, his track record after 100 days ranges from disappointment to dismal failure — a pattern of promising a supersonic jet and then delivering a trial balloon that flies like a lead Zeppelin. (I could go on.) Meanwhile, U.S. GDP grew by a paltry 0.7 per cent in the first quarter — the worst Q1 growth in three years. Anyone who doesn’t at least question the Trump economic bump, and by extension the longevity of the Trump rally, needs to give her head a shake.

And yet, while the political impetus behind the rally might be weakening, that doesn’t mean the rally is over. Inferring that it is, from bond yields and policy stagnation, might be reading too much into both bond yields and policy stagnation.

Even without Trump’s stimulus, the U.S. economy looks to be doing OK over the long term, at least in the Fed’s view. Chair Janet Yellen, in holding rates steady Wednesday, dismissed the dismal first-quarter GDP number as “transitory,” and pointed to strong employment, firmer business investment and inflation that’s near target. The Fed looks set to raise rates in June, and her comments did nothing to suggest that Washington’s inertia will push the economy off its growth trajectory.

But aren’t falling yields signalling slower growth ahead? Well, yes, maybe. But it’s not a one-toone relationship. For one thing, some of the recent buying in bonds might be opportunistic. With yields rising by more than 100 bps over three quarters, they become more attractive, right? So you buy them — an especially tantalizing opportunity if you’re, say, in Japan, where government bonds yield next to nothing. And for other investors, the prospect of higher rates not materializing might be just enough to lock in gains. Another factor is that fixed income markets don’t behave like stock markets do. That’s in part because big players — institutional investors like pension funds and insurance companies — have different motivations than the average RRSP holder. Pension funds, for instance, don’t just save for retirement — they save for other people’s retirements.

Increasingly since the recession, pension funds’ investing view is toward risk — namely, the risk that they might not have enough money to pay their retirees. With time horizons measured in decades, not quarters, they’re not worried about shortor even medium-term volatility. They buy bonds to match returns to future liabilities. So even if yields are low, or inflation is gaining momentum, or Donald Trump delivers on growth, institutions will still hold bonds, and then buy them again when they mature, because of the vital role they play in risk management. That tends to maintain demand, which keeps yields in check.

Anyway, if nothing else, what’s obvious is that the meaning of falling bond yields is non-obvious. They might be signalling many things, but the end of the bull market isn’t necessarily one of them.