The Message from the Bond Market is Very Different than the Stock Market
It is said that bond investors understand the path of the economy far better than stock investors. And at times, like this, it all can be somewhat irrational. The current economic backdrop is a strong case in point—talk about confusing. Stock investors often get caught up in the story. The data is getting less bad—that is very true. The markets are forward looking. Bond investors weigh inflation and growth expectations along with supply and demand factors. Today, supply and demand analysis has never been more challenging—the central bank intervention has rendered traditional analysis near useless. Inflation expectations seem to change by the hour. Recent yield curve movements appear to be pricing some reflation and some inflation. The colossal degree of debt supply coming in the next few years and beyond is staggering. The output gap caused by COVID could take years to recover. The amount of increasing debt to GDP globally is killing the longer-term growth outlook. We are almost certainly going to face a decade or more of stagflation ahead. The only way to reduce the size of the debt is to print money and deflate it. The central banks of the world have started in earnest—including the Bank of Canada. Stock investors see low rates, few alternatives, lots of liquidity, and are plowing money into storied stocks with unclear earnings outlooks. The fundamentals have never been more distorted. We continue to see this as troubling, the bulls see the liquidity as a reason to buy buy buy.
At noon Friday, Fed funds futures see rates staying at the lower zero bound for several more years. The implied yield of overnight money is 100 minus the price of the contract. The slight rise in the price of the contracts to 100 in mid 2021 suggest the possibility of negative rates, though that has changed follow the surprising employment reports today. For those at home you can follow prices on the CME website.
The next most sensitive rate are the floating rate 3-month Eurodollar futures, which trillion of dollars around the world are traded in the swaps market. There is a 10-year series of 3 month interest rates called the Eurodollar futures curve. This rate represents the rate that banks lend to each other known as the London Interbank Offer Rate (LIBOR). So it tends to be a bit higher than the government rate because there is a small degree of credit risk. This curve suggests the first rate hike might be in the second half of 2022 and by the end of the decade the 3 month rate will be about 1.5%.
Longer-term rates are largely driven by growth and inflation expectations, but for the past decade, central bank buying of government debt to keep rates low and support the economy has distorted all yields globally. Japan has been the leader in this experiment of yield curve control. They have led the world followed by Europe to negative longer-term yields. The rest of the world has followed. Today, the US 10-year is the highest yielding safe debt in the world. We still see this rate trading at negative yields before the bull cycle ends for bond yields and the recession\depression effects of this cycle are over.