Wednesday, June 15, 2016

Bond Yields and the Stock Market: A Longer Term Perspective

The daily gyrations and noise of the financial markets are these days exacerbated by algorithmic machine-trading. In addition, the high inter-connectedness of global markets and availability of instantaneous information leads to high correlation between all asset classes: equities, bonds, commodities and currencies; leading to higher and higher volatility via feedback loops until it crashes (nothing goes on forever in such Chaos theory models). Like what happens when your electric guitar's signal feedback to the amplifier turns into a howl.
Taking a longer term view helps in taking away the noise to view the fundamentals. The chart below shows US interest rate changes from 1965 to the present, as represented by the yield on 10-tear Treasuries. Superimposed on it, the Dow Jones Industrial Average and Singapore's Straits Times Index. The chart scale is logarithmic and changes are in % for comparability. The second chart shows yields for 5-years so that details can be viewed with greater clarity.
Some observations from the two charts:
- Today's 10-year Treasuries yield of about 1.59 is low but not the lowest. The lowest of 1.35 was sometime in July 2012 when the PIGS (Portugal, Italy, Greece, Spain) had problems with their sovereign debt. (Can't remember whether it was Italy or Ireland. More recently it was Iceland
- But that was temporary and you can see the yields going up rapidly until it reached a peak in 2014.
- However since then it has been on a downward slide except for the period Jan to Jul 2015
- Taking a longer term view. Since 1965, the yields (interest rate) are definitely indisputably dropping. That's a 50 year trend!
- Next thing you may notice is that broadly speaking, stock markets move in opposite direction to bond yields- see the DJIA and STI on the first chart.
- Singapore and its very open economy is vulnerable to all sorts of happenings around the world. See circled 1997 Asian financial crisis and 2008 US sub-prime mortgage crisis.
-As a result of the low interest rate environment,there is economic growth but also asset growth fuelled by debt (asset bubbles)
- China is a such a good example, and many economists expect a day of reckoning soon which will make the impact of Brexit pale in comparison.
Why is a low-interest rate environment so persistent? I don't know the answer. My guess is that it is due to politics and politicians. Every time economic growth slows down for valid structural and cyclical reasons, politicians are afraid that they will loser their votes, or there will be social unrest. And so they prime the pump to let loose the money again.
Scott Lee for you since you seem to be more interested in economics and finance these days.

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