Judging from commentary on TV and around the web, there is increasing concern about the divergence in stocks (DIA) and Treasury yields (IEF) that has transpired this year. On Friday, the 10-year yield went as low as 1.68%, and this is considered a sign that the stock market has failed to take notice of a deterioration in underlying conditions. The unemployment numbers did not seem to help the bull case very much, and gold saw a nice little pop.
The relationships that I use to guide my projections about long-term stock behavior suggest that overall conditions strongly resemble those we can associate with a bull market akin to the 1980s and 1990s (or possibly the mid-1970s). In my last article, I hope I did something to put a dent into the notion that falling commodities are necessarily bearish for equities. Sometimes it can mean that, but more often than not, this is a bullish signal, and the steady unwinding of the precious metals trade should reassure us that that is the case this time.
But, I have been intrigued by the arguments that interest rates should be confirming rising stock prices by rising alongside them, and I have been surprised how often it has been repeated in recent weeks. It is true that for the last fifteen years, equities and interest rates have marched more or less in sync, but I think it is important to note the increasing likelihood that the themes of the 2000s - strong commodities and emerging markets alongside weak developed-world equities - are steadily evaporating. And, therefore, it is increasingly likely that correlations peculiar to the last decade will unravel.
I believe we may be seeing that now, especially in the behavior of somewhat deeper, more long-term market forces, but also in the deterioration of correlations that are on the minds of many market-watchers at the moment.
In the chart below, I have inverted the three-month (red) and ten-year (orange) Treasury yields and put them alongside the Dow. You can see that during the 2000s, a period during which equity yields and interest rates began to part ways, stocks tended to slide into bond strength. But, during the period when equity and Treasury yields were highly correlated with one another (remember the Fed model?), strong bonds were as likely to go hand-in-hand with strong equities as not. Especially if we remove bear markets apparently brought on by flat yield curves and/or oil shocks, there was a negative correlation between equities and bond yields.
I am not saying that it is natural for equities and bonds to correlate (I doubt that it is), but under our monetary system, it seems rather evident that they often do, and most of the intermarket indicators seem to suggest we are reverting to the Really Old Normal of the '80s and '90s rather than the Old Normal of the 2000s.
One could, I suppose, also point to the nasty employment numbers to confirm us in our fears, but the rate of unemployment continues to fall, consistent with rising P/E ratios, and, in any case, employment generally seems to be a lagging indicator. In fact, it is much more likely that falling commodities and rising stocks are pointing to falling unemployment in the future rather than unemployment pointing to imminent stock market trouble.
Of course, I don't know that equities will not follow yields down in the near-term. But that being said, I simply have not seen any arguments that convince me that market participants should adopt an overly negative stance based on either falling yields or commodities.
In fact, rather than focusing on the relationship between American equities and interest rates, perhaps what we should be pondering is the breakdown in the relationship between Japanese stocks (NKY) and U.S. Treasury yields. They appear to have been highly correlated with one another since the 1990s, but this correlation also appears to be under increasing strain, first breaking down after the precious metals spike of 2011 (which I hold is a typical conclusion of a secular bear market) and then appearing to come wholly undone once the Japanese stock market boom began last November, presumably due to the political momentum in favor of aggressive monetary expansion that brought the LDP back into power.
Again, it is far too early to be dogmatic about this, but I think there are definite intermarket rumblings setting us up for the next market "theme" that typically emerges to justify market moves after the fact.
(Source: Wren Investment Advisers, Nikkei.com, St Louis Fed)
This apparent change in Japanese momentum, combined with the outperformance of the Dow, suggests that there is a new narrative taking hold in this market, one that is increasingly reminiscent of the aftermath of the previous commodity bust in the 1980s.
In sum, it is true that there has been a fairly nice correlation between stocks and interest rates for the last decade or so, but both a) the behavior of U.S. and Japanese equities relative to BRICs (BIK) and to interest rates and b) the behavior of commodities (GSC) across the board suggest to me that we should reconsider our assumptions about certain market relationships that we have grown used to since the late 1990s. More importantly, for those interested in long-term trends, they should rely on those intermarket relationships that have exhibited the greatest amount of longevity, namely those that are centered on the behavior of equity yields. And those are telling a pretty convincing story of stock market strength and commodity weakness.
Additional disclosure: I am long June Dow futures.