Can Stocks and Bonds Go Down Different Roads?
If the bond market zigs, the stock market zigs. If the bond market zags, the stock market zags. Many investors have come to believe that this is immutable law, perhaps from Moses himself.
But is it? If interest rates jump and bond prices fall, must stock prices decline as well?
We may retest this “law” soon, because the bond market is getting antsy about the prospects for stronger economic growth ahead, while the stock market has been rallying powerfully.
On Thursday the bellwether 30-year Treasury bond yield surged from 6.09% to 6.16%, putting it back where it was on Feb. 2, and leaving it significantly above the 1995 closing yield of 5.95%--even though the Federal Reserve Board cut short-term rates on Jan. 31.
Thursday’s rise in yields occurred after a couple of economic reports suggested that business activity hasn’t been as weak as most economists--and apparently, the Fed--have come to believe. The government said factory orders were up in December, even excluding a surge in airplane orders. And in a more timely report, the Fed’s Philadelphia branch reported a slight rebound in regional business conditions this month, after a weather-related dive in January.
Of course, only a desperate presidential candidate would try to make too much out of a few bits of economic data. There are plenty of signs that the U.S. economy remains stuck in low gear, perhaps bordering on recession. Still, the bond market’s unwillingness to go along with the program this year is hoisting eyebrows. Even more disturbing is that long-term bond yields have been rising in Japan and Europe as well recently.
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“Historically, the bond market tends to signal turning points in terms of the weakness or strength in the economy before the ‘official’ economic data do,” notes Paul Kasriel, economist at Northern Trust Co. in Chicago.
He doesn’t expect more than a “modest pickup” in the economy in the second half of 1996. Even if he’s right, however, we don’t know what level of long-term yields the market will decide is proper for that faster growth rate, for the prevailing inflation rate, and for whatever phase the federal balanced-budget follies are in by then.
Let’s assume the worst, and that bond yields continue to edge up between now and autumn. Can stocks’ 1996 rally keep going? Most investors have been so conditioned to think of rising rates as bad for stocks that a continuing rally might seem impossible. Indeed, the Dow industrials have been slipping since Tuesday as yields have risen.
Yet there have been times when stocks and bonds have gone their separate ways: Interest rates have risen because of a healthier economy, but the stock market has advanced anyway on expectations of stronger corporate earnings.
In fact, Salomon Bros. investment strategist David Shulman says that was often the norm pre-1972. From 1930 to 1972, “The movements of the real economy dominated the pattern of returns, with a strong economy generally being positive for stocks and negative for bonds,” Shulman says. Things changed with the scourge of high inflation in the 1970s, he says. Because rising rates became synonymous with rising inflation--and not necessarily with faster economic growth--stocks began to move in tandem with bonds.
But if more investors come to believe that inflation has been licked in the ‘90s, Shulman says, the old stocks-bonds relationship may return. In other words, stocks can zig while bonds zag.
That actually was true for many stocks in 1994, even as the Fed doubled short-term interest rates, says Wall Street economist Henry Kaufman. This year, he says, how stocks perform may depend more on whether the Fed is simply content to leave short-term rates “anchored” where they are, even if long-term bond yields go higher.
Individual investors tend to pour money into stocks when yields on shorter-term bank CDs and money market funds are low, Kaufman notes. Most people, after all, don’t buy 30-year bonds. Thus, rising long-term bond yields may not dampen investors’ current attraction to stocks.
Lastly, let’s not forget 1987: Short and long rates alike rose that year, but the stock market was so excited over the economy and corporate earnings that it surged anyway. The Dow industrials gained 43% between January and August. But of course, we all know how that one ended.
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Widening Spread
Bond investors’ jitters over a potential economic revival have boosted long-term bond yields in recent months, while short-term rates have continued to edge lower. 30-year and 3-month Treasury security yields, weekly closes and latest:
3-month T-bill: 4.91%
30-year T-bond: 6.17%
Source: Bloomberg Business News
