Stocks vs bonds: which are correct?

The sharp fall in bond yields suggest troubled times ahead for the global economy. Yet the stock market continues to surge. Which do you believe is right?

Government bond markets are priced for economic weakness which is in contrast to the recent bull run in global stock markets. Having had a mildly bearish move a few weeks ago when bond yields rose on the expectation of a steady economic improvement and a risk of higher inflation, the recent trends show a sharp reversal and a meaty drop in yields.

If any analyst was relying on the bond market pricing for a guide to the economic outlook and risks, they would reach a clear judgment that weak growth, downside inflation risks and potential economic gloom were likely in the near term. It would not be a nice scenario.

To illustrate recent bond market trends, the US 10 year bond yield has moved from trading as high as 2.05 per cent within the last two weeks to now be yielding 1.85 per cent. Because bond prices have an inverse relationship to bond yields, this is a huge price rally in such a short time.

The rally in bond prices has been seen in other markets.

In Japan, the 10 year bond yield is staggeringly low at 0.52 per cent while the 5 year yield is 0.12 per cent. The market is reacting to the policy stimulus agenda of recently elected Prime Minister Abe, who is aiming to stoke inflation, pump prime the economy with a range of fiscal measures and rekindle growth.

In Germany — the safe haven for European investors spooked by the problems in Cyprus and fears of contagion — the 10 year yield has dropped to 1.27 per cent while the 2 year yield is again negative, at -0.02 per cent. Investors are happy to lose a little bit of capital (the negative interest rate) to make sure the bulk of their capital is protected.

The bank deposit levy that dogged policy makers in Cyprus is seen as a risk for the other fiscally challenged countries including Greece, Portugal, Spain and even Italy. Whatever the merits of that policy, it has sparked a genuine risk of capital flight as depositors shy away from the threat that these savings could be subject to a hair cut in a quick fix to the fiscal woes.

It is too early to be sure whether the bond market has it right when more troubled economic times are being priced in. Critically, many central banks are still implementing quantitative easing which means ongoing buying of bonds. This is a clear distortion on the market — without QE, bond yields would be higher.

Also confusing the picture is a still buoyant stock market. While there has been a general consolidation in share prices in the last few days, stock markets are strong. If the recent trends in share prices are used to try to forecast the economy, one would have an upbeat view. After all, share prices rarely sustain such strong gains unless investors are pricing in stronger growth, higher profits and higher earnings.

It is a scenario of bonds versus stocks. Which is correct or rather, which one is the most reliable in terms of forecasting the economic outlook?

Given the clear distortions in bonds at the moment, with many central banks implementing QE and artificially driving yields lower, my money is on the stock market having it right. That is, the rise in share prices is giving a better signal that economic conditions will, more likely than not, be stronger through the course of 2013.

It is good news. It is implicitly the wish of central banks to see stock prices (and asset prices more generally for that matter) to move higher. Wealth is boosted, biasing consumer spending higher. Bank balance sheets also improve which, in time, will give them confidence to ramp up lending opportunities, a vital trend if economic growth is to remain solid.

Conditions are still favourable for global growth in the year ahead. The stock market certainly points to a rosy scenario. The bond market, conversely, is suggesting the opposite, but it is being distorted by central bank activity and not so much from real-money investors positioning their portfolios for a return to recession.

It will be critical to see how bond yields perform in the weeks ahead. Any further large falls might be a sign of real-money flows which would be significant. If this were to happen when stock prices were also falling, it would be worrying and the economic outlook would turn bearish.