Bond markets are where institutional investors commanding the largest pool of savings PRICE their economic expectations for the future.
The level of bond yields, and even more, future bond yields, is what savings are prepared to earn to lend to corporations and the economy.
If the demand for credit is strong, as is the case in economic expansion phases, then bond yields tend to rise as demand for capital outweighs the supply of savings
If the demand for credit is weak, as is the case in economic contraction phases, then bond yields tend to fall as the supply of savings outweighs demand for capital, and investors are prepared to earn less for lending.
Today, the messages sent by equity markets and bond markets about their future expectations for the US economy are in total opposition…
If one listens to the US bond market, there will be no V-shaped economic recovery in America, and maybe not even a U-shaped one either….
Instead, there is greater likelihood America’s recovery will have an L-shape recovery, especially if COVID-19 lingers around.
By the sound of the US bond market and the increasing talks about negative interest rates, America could well wind up looking like Europe or Japan, with a non-negligible probability of a Depression similar to the one of 1929.
That is the bond market’s views if one is to judge from the sticky level of bond yields and the low long term expectations they project.
30-year bond yields have never been that low in America….
The major U.S. stock indexes seem to be saying:
“No really, everything will be fine! the economy will recover fast, the downdraft will be limited to 2020, corporate earnings will recover and even surpass 2019 levels and corporations will re-hire the workers they have just laid-off.”
Whereas the bond market is saying:
“What you see on Main Street is real. The economic carnage you see and quite possibly feel yourself — through friends, relatives, or your own small business — is real. It’s going to take a while to recover from this.”
But let’s see why the bond market looks so bearish…
The bond market is deeply bearish on two fronts.
The first one is the two-year U.S. Treasury yield.
On Feb. 24, just after the S&P 500 topped out, the two-year U.S. Treasury yield was 1.36%. As the market crashed, that yield plummeted toward zero — and it hasn’t bounced back. As of this writing, the two-year Treasury yield is 0.16%.
The long-term average for the two-year Treasury yield is 3.32%.
This means that, even before the February-March market crash and pandemic-related shutdowns, the two-year yield was less than half its long-term average. That is a sign of economic weakness. When yields are low, borrowing demand is weak, which means economic vigor is lacking.
The chart above illustrates perfectly how 2-year yields start climbing when the economy recovers, see 1993, 2003, and more recently 2016-2017.
But every time they fall sharply, as they just did following the TWO consecutive deflationary shocks of the US trade War and COVID-19, they point to economic weakness ahead.
If hopes for a V-shaped recovery were grounded in hard reality, the two-year yield would have started to move higher already, reflecting rising demand for capital and greater circulation of economic activity in the lifeblood of the U.S. economy.
The bond market’s second message is even grimmer.
The Fed funds forward curve is forecasting negative U.S. interest rates starting in summer 2021.
Federal funds futures are the marketplace for anticipating the future direction of interest rates.
Commercial players use Fed funds futures to “hedge” their exposure to future interest rate decisions of the Federal Reserve, in the same way crude oil futures are used to hedge crude oil exposure, soybean futures are used to hedge soybean exposure, and so on.
Even as the stock market indulges the optimists with a shiny, happy interlude, the Federal Reserve — as anticipated by the Fed funds forward curve — is expected to go below zero in about a years’ time, joining Europe and Japan in the land of negative rates.
Federal Reserve Chairman Jeremy Powell is officially adamant this will not happen, of course. But that is the only stance he can take. For the Fed to admit that “yes, negative rates are on the horizon” would be tantamount to forecasting economic doom, or admitting outright that America is becoming like Japan.
However, the truth is that the FED has no more option at its disposal apart from this one if the economy does not kick-start before the end of the year.
Lending is NOT spending
Equity markets have gone uberly bullish because of the unprecedented magnitude of the fiscal and monetary stimulus plans announced recently, with Congress just passing a bill for US$ 3 trillion of fiscal authorization.
However, the Fed can lend like crazy, buy the entire US corporate bond market and the Government provides guarantees to companies borrowing money to survive but they cannot make consumers spend if consumers are worried about their future, their jobs, and their finances.
Surely, 3 trillion dollars is a huge amount that catches the imagination of investors, and almost every country around the world is taking similar steps of similar magnitude.
But the real question is what do these trillions compared to :
- Is a few trillion dollars “a lot” in comparison to between 12 million and 15 million US small businesses going under?
- Is it a lot relative to Great Depression levels of economic contractions – 32 % according to Goldman Sachs and unemployment already heading towards 20%?
- Will it be sufficient in an economy that is 70% driven by consumer spending, and that is now seeing consumers slam on the brakes, with no telling when their psychology or their battered wallets will mean-revert? especially if real estate prices and stock market prices do fall as would normally be the case …
De-leveraging has already started
The most recent data point for the monthly change in U.S. consumer revolving debt levels was negative $28.176 billion.
What this means is that, across all the credit cards and home equity lines of credit, Americans have already lowered their collective balance by more than $28 billion in April.
The normal pattern over the past few decades has been to see that revolving balance rise every month, to the tune of single-digit billions.
So a print of – $28.176 billion is another sign that something that “never happened before in history” is happening.
Here, as in so many macro-economic datapoints, the decades-long chart is blown out of all its historical ranges testifying that something truly dramatic is happening with US consumers.
What this huge drop in consumer debt balances means that US consumers are slamming the brakes on spending and increasing their savings at an unprecedented pace.
When the government and the Fed sprays money at consumers and they take that money and pay down debt with it or save the money for the hard times ahead, the monetary velocity of those stimulus funds becomes zero.
The new stimulus funds are consumed by debt loads and a savings gap and the debt is just transferred to the Government with no real economic multiplying effect.
What the two-year yield hugging zero, and Fed funds futures forecasting negative rates by summer 2021, are telling us is that the American economy is probably going through the most deflationary event in 8 decades and that the impact of that deflationary shock is just beginning to be seen in the data.
So, what about the stock market then?
Have US equity investors lost their minds, bidding up the indexes and the leaders of the markets to unprecedented valuations?
The first thing to note is that the stock market has always been a terrible barometer of the actual U.S. economy. Never have bear markets announced recessions, they have always followed them.
The second thing worth noting is that equity analysts, strategists, and investors are actually TOTALLY BLIND today. Never in history have such a proportion of CEOs refused to give any business or earnings guidance for the coming year and next. Analysts are totally unable to make predictions and they cling to historical models that are made irrelevant by this unusual shock.
The third point is that the consensus of analysts and strategists has NEVER timed the beginning of bear markets properly in the past. Analysts are people who project the known past into predictions for the future, they are not good at detecting trend changes.
The fourth point is that investors have pavlovian reflexes. In December 2018, the FED changed the course of its monetary policy and resumed quantitative easing. That stopped the sell-off in equities and unleashed the strongest rally for years in 2019, despite extremely e=weak economic and earnings that year. In fact, corporate earnings declined in 2019, at a time where equities rose by 30 % fuelled by the money injections of the FED. Investors are therefore simply following this simplified road map and hope that the FED. will always bail their greed out, regardless of fundamentals.
Finally, in the financial industry, it is more rewarding to be wrong with everybody else that right on your own. This is a big bias of the mainstream banks where analysts and strategists are NOT rewarded for being right but for not diverging too much from the consensus. If you add to that that NO MAINSTREAM financial institution will EVER tell their clients to bail out of equities and that we are going into a bear market, for obvious conflicts of interest with their franchise which is to keep investors invested and trading, then you understand the current irrational bullishness.
History shows that it is always better to listen to bond investors than to equity investors when it comes to predicting the future course of any economy.
The US Bond market points to the WORST ECONOMIC RECESSION of the postwar period and future negative rates point to the fact that there will be no quick recovery.
Corporate earnings are bound to suffer greatly ahead, and NO recession ever took place without a bear market in equity happening as well.
Bear Market rallies are the norm. What is abnormal today, is the speed at which the traditional phases of the bear market are unfolding… And this is NOT a good sign…