The relationship between the yield on stocks and the yield on bonds is inverting in a way that hasn't been really since before the 1950s. But the concern regarding this "strange" behavior should stop. The strength of bonds (both Corporate and Government alike) is a reflection of a healthy and necessary shift in the capital structure of our economy.
Investors have pulled 50 billion out of the US stock market this year. This money has gone into cash (both Savings Accounts and Gov't Bonds), corporate bonds (Junk and Investment Grade), and ex-first world equities.
The foreign equity story is simple. Countries with strong property laws, stable governments and a youthful demographic, will see an increase in economic growth as people compete to raise their own standard of living.
But the massive amount of money that has moved into fixed income, has bewildered many market commentators. The extremely low yield of both regular and inflation-protected Government Bonds has many people worrying about deflation. They are right to worry. Cash parked with the government is money not spent. The momentum of money is slowed down.
This adjustment is part of a larger system of balanced interactions. The shifts in money flows cause prices to change. These prices act as signals, encouraging shifts in the behavior of participants. These behavioral changes in turn, affect money flows and the process is repeated.
Lets trace the path of these signals. Falling stock prices scare people. This is because these prices telegraph signals about the health of an economy. People decide to hold more cash, which means either directly or indirectly purchasing government bonds. This allows the government pay a lower rate to borrow money.
But message contained in Gov't Bond rates is more multi-faceted than simple warning of deflation . It is also a reminder to investors that if they want to earn any return on their money at all they will have to take some risks. If they are forced to invest in something, their best option is to choose the second safest thing to cash, loaning their money to corporations. We can confirm this behavior signal by observing the large money flows into Corporate Bonds beginning about a year and a half ago and continuing to the present day.
This behavior shift has lowered corporate borrowing rates to the lower range of their historical levels (and when I say historical I mean as far back as two hundred years.) We have seen an enormous shift in the cost of borrowing for corporations since the darkest depths of the financial meltdown. In December 2008, the price at which an investor could be persuaded to lend money to riskiest corporations hit a level which implied he figured his risk was 50/50. Even the rates on the best run corporations were implying defaults of nearly 10%.
This flow of money, signaled by the extremely low corporate rates (I.B.M. just borrowed some money for less than two years at a rate of 1%) is telling us that the best run companies in their respective fields are going to be allowed to continue to do good work. Times will get tough in the months ahead, the stock market will fall. But the necessary shifts in our economy will now have the chance to occur. The process of creative-destruction will remain in balance and the engines of creation will not be helter-skelter destroyed.
All we are witnessing is a cyclical transformation in our economy from its recent youthful speculative exuberance to a more considered, mature and frankly world-weary countenance. Keep hustling, and it will be ok.
Extra Credit / Required Reading:
- Dollar Strength on Recognition of Worldwide Crappiness
- Robinson Crusoe and the Subjectivity of Desire
- Reflections on Today, from Henry Clews, 1908.
- Art Market Rules
- The Long View... 1885-2009
- Forecast: The Battle Between Paper and Tangible Assets, A Personal View
- Tobin's Q
- Luxury Goods
- After the Gold Rush...
- The Gaussian Fallacy and other Bullshit Baby Boomer Epistomologi
- Douchebag of the Noughties
- Synopsis of the Panic of '08
- You Know its a Bubble When...
- Quantitative Easing
- Vallejo, CA