Israel gold bullion coins money wealth economy 370.
(photo credit: Eli Gross/Keren Or)
The outstanding features of the financial markets in recent weeks, especially in
the US, have been that share prices are rising and bond prices are falling. Each
of these phenomena on its own is subject to the usual debate as to what is
causing it. But finding an explanation that fits both at the same time is more
Most analysts – including the mainstream ones working for big
banks and investment houses, but especially the ones who think and work outside
the consensus – believe that the key factor behind the ongoing rise in shares is
the unprecedented liquidity being injected into the financial system by the
central banks, including the Fed, the ECB and the Bank of Japan.
even agreement that corporate “fundamentals,” meaning the level of earnings and
expectations of future earnings, are not good enough to justify the ongoing
uptrend – and, indeed, the most recent set of earnings has been generally
disappointing. The macro-economic picture is weak or, in the best
interpretation, not strong.
But in that case, and given how low inflation
rates are, bonds should still be in demand and their prices should be rising
while their yields fall. Yet, for the last year, bond yields have been rising.
To make matters worse, from an analytical point of view, government bond yields
have risen sharply, despite the fact that the Fed is engaged in buying no less
than $85 billion every month of US Treasuries and mortgage debt issued by
government agencies. This alone should have put a floor under bond prices and
ensured that they would not fall.
Yet fall they have. The yield on
10-year US government bonds is currently around 2.7 percent, almost double the
record-low level of 1.39% reached last summer. Thirty-year bond yields have
risen even more and are now at 3.7%, which has fed through into a sharp rise in
mortgage lending rates.
That, in turn, has sent the demand for new
mortgages plunging, and crushed the “refi” market in which borrowers refinance
their existing mortgage by taking out a new loan at a lower interest rate. These
developments threaten to undermine the recovery in the housing market, which is
a key component of the overall economic recovery that the Fed’s aggressive
monetary policy is aimed at spurring.
However, there is a simple way to
explain both rising share prices and falling bond prices. It’s called economic
When an economy recovers from a recession, especially a deep
and prolonged one, there is a stage in which the equity market does well –
because the nascent recovery implies rising profits in the future, while bond
prices fall because the recovery is expected to translate into stronger demand
for loans – meaning higher interest rates – and cause higher inflation, which is
bad for fixed income securities, a.k.a. bonds.
In other words, if
you believe that the US economy is recovering and that growth is going to
improve, so that loan demand rises and inflation too, then it all makes sense.
Better still, the outlook is rosy and – at last – all will be well. The economic
data released Wednesday – or at least some of it – supports that
But not everyone is willing to buy into that happy
First of all, the recovery has supposedly been underway for four
years, during most of that time bond prices fell. Secondly, as soon as the Fed
hints that it may reduce its bond purchases, all the financial markets tank –
suggesting that without the artificial support they are receiving from the Fed,
they have no strength, and refuting the idea that they are responding to a
recovery in the real economy. Furthermore, if rising interest rates threaten to
choke off whatever recovery there is, then there can’t have been very much to
There is a more ominous explanation of the phenomenon of
rising interest rates. It says that rates are not rising because of an incipient
recovery, but because lenders are getting increasingly worried about the ability
of borrowers to pay.
The underlying financial condition of cities and
states in the US and of countries in Europe is, in a word, terrible. Detroit, as
discussed here last week, is likely to be the first of many major cities to
admit it cannot pays its debts, let alone meet the promises it extended to its
employees for pensions and healthcare. This approach doesn’t attempt to
reconcile the boom in the equity market – dismissed as “la-la-land” – with the
decline in bond prices, seen as “reality.”
It is greatly to be hoped that
this is a mistaken view, but hope is not a sensible basis for making decisions.