Two areas of concern for markets…

When everyone is bullish about the economy and markets (including yours truly), it’s time to look at page 16 news. 

Page 16 news is important, but doesn’t seem important enough–yet–to make it to the front page of the newspaper.  By the time a piece of news hits the front page, it’s already priced into markets.  One should look at page 16 news to know what hasn’t been priced into markets (hat tip to Donald Coxe).

What important news is on page 16 and should be on page 1?  1) Long term bond prices have been dropping hard and 2) oil prices are steadily rising to high levels.

Despite the Fed’s efforts to drive short and intermediate term interest rates lower, long term rates have been rising (yields rise when bond prices fall).  This is important because long rates reflect the market’s assessment of inflation, and because long rates impact meaningful borrowing rates, like mortgages.

The yield on 10 year Treasury bonds have gone from 2.4% to 3.5% over the last 4 months.  That’s a roughly 9% decline in the price of a 10 year bond.  During this same time, the stock market has rallied almost 20%.  As I’ve said in this space before, bond and stock prices should not be moving in opposite directions over the long run.

(Geek’s note: stock prices reflect cash flows discounted over time.  I’m willing to pay $0.91 for $1 of earnings a year from now if I want a 10% return.  That 10% desired return is the discount rate and the $1 I get a year from now is the cash flow.)

Stock prices should reflect long term bond yields.  All things being equal, when long term bond yields rise from 2.4% to 3.5%, this higher discount rate should drive down the price of stocks by over 30%!  Now, as you may have guessed, all things are never equal.

Some believe stock prices are rising and bond prices are tanking because investors are more optimistic about the economy.  I disagree with this position.  Long bond yields rise because of inflation, and inflation is bad for stocks.  Bonds and stocks tanked in the 1970’s as inflation fears rose, and rallied strongly in the 1980’s and 1990’s as inflation fears shrank to nothingness. 

Bond prices do rise and stocks tank when deflation is the fear, as has been the case during the last decade.  But, bond prices tanking and stocks flying because investors are optimistic about the economy?  I can’t think of any historical examples to support that.

Keep in mind, too, that long bond yields also impact mortgage rates.  If long bond yields are going up, so are 30 year mortgage rates.  How exactly is giving an already disastrous housing market an additional headwind of higher priced mortgages supposed to be good for stocks and the economy?  I can’t think of a good reason.

The spike in bond yields may be a temporary phenomenon, and that is my guess about what’s happening.  If bond yields come back down below 3%, that would seem to give the all-clear signal for stocks (at least, for a while).

The other page 16 news is oil prices hovering around $90 a barrel.  The last time this happened, in late 2007 and early 2008, the U.S. economy was entering recession. 

Higher oil prices lead people to consume less.  It tends to act as a natural governor on the economy–when energy prices spike, it tends to slow the economy.  Oil prices impact heating costs, travel costs, grocery costs, pretty much everything.  And, if you have to pay more for those things, you don’t have money left over to buy that new electronic gadget you’ve had your eye on.

Just as long bond yields declining would give the all-clear signal for stocks, so would be declining oil prices (below $80 a barrel). 

But, as long as long bond yields spike and oil prices keep rising, bad news is brewing for the stock market and economy. 

I don’t have any illusions that I can predict such events, but I will be watching with great interest to see what happens.  If long bond yields and oil prices hit the front page, it’ll be too late to do anything but cry in your beer.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Two areas of concern for markets…