We’ve been looking at the messages markets have been sending about economic expectations. Investors are future-oriented; that is, they buy or sell various types of assets based on what they think will happen in the future. They don’t know the future with certainty, because no human being does. However, markets involve many millions of investors, which means they incorporate a very wide array of information held by people throughout the world.
What we’ve learned so far in this series is that the recent rises in 10-year treasury yields, which have gotten a lot of attention lately, only tell us one small part of the story: they tell us that demand for treasuries has been dropping. However, we can’t know why demand for treasuries has dropped without looking at what investors have done with the money they took out of the treasury bond market.
We see that one thing they’ve done is to buy investment grade corporate bonds. That implies investors probably do not expect a deflationary growth slowdown. Corporate bonds are attractive if one does not expect a serious slowdown (like a recession) or if one does not expect deflation. Corporate bonds tend to do well relative to treasuries when growth is high, inflation is high, or both. The demand for corporate bonds is therefore probably either signaling high inflation and/or high growth. In order to figure out which factor is probably driving the exodus from treasuries, we need to look at whether some of that money is flowing to stocks, and whether some of that money is flowing to inflation-protected securities like Treasury Inflation Protected Securities (TIPS).
If money is flowing out of treasuries (which are not growth-sensitive) and into stocks (which are growth-sensitive), their yields would converge, and that would mean markets are likely registering optimism about growth. If the money is flowing out of treasuries but also flowing out of stocks at about the same rate, then the spread between them would stay stable, and that would indicate little or no change in growth optimism. That’s pretty much what we saw in 2021.
However, there was volatility throughout the year. Early in 2021, the yields diverged as money rushed out of treasuries into stocks, an optimism indicator. But then the spread rose again, indicating risk, and the spread was about the same at the end of the year as it had been at the beginning. This means that in 2021 the stock story was less optimistic than the corporate bond story. Remember, corporate bonds aren’t a pure growth play, they’re also an inflation play. So, the data we’ve seen so far is consistent with lackluster growth expectations and concerns about inflation. Although the data does not extend beyond the end of 2021 as of the date of publication, broad U.S. stock markets have shown negative performance, indicating a further deterioration in growth expectations.
To complete the story, we’ll need to look at the relationship between the conventional 10-year treasury and TIPS. We’ll see below that the yields between the two of them diverged during 2021:
This represents a shift away from the kind of treasury that doesn’t protect against inflation towards the kind of treasury that does, which strongly suggests a rising fear of inflation. In fact, the fear of inflation is so strong that during the entire year, TIPS were in such high demand that they offered a negative yield. In effect, this means that investors were willing to pay the federal government to hold their money for them, like in a safe deposit box, in exchange for the promise that when the principal was returned at the end of the bond term it would be adjusted upwards for inflation.
So, the rise in treasury yields is a shift towards corporates (which is consistent with stagflation1 expectations), not a shift towards stocks (which is consistent with stagnation expectations), and a shift towards treasury protected bonds (which is consistent with inflation expectations).
Market trends are pointing towards stagflation — more than pointing, they’re yelling it out as a warning for all to hear.
1 Stagflation refers to an economy that is experiencing a simultaneous increase in inflation and stagnation of economic output.
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