Stocks and bonds get untracked

By the end of May, the decline in the benchmark 10-year U.S. government note yield to 2.40% marked its lowest reading since July 2013.

The topic du jour on most financial media talk shows immediately became why bond yields were seemingly responding more to the earth’s gravitational pull and ignoring the imminent monetary tightening that the Federal Reserve was clearly embarking upon.

Meanwhile, stocks continue to enjoy the summer heat and appear unflustered by a slew of nasty geopolitical risks in the background. 

The cornerstone of the bull market for equity prices is to be found in the Federal Reserve’s unconventional policy of buying bonds and reinvesting proceeds from maturing securities. While the policy has undoubtedly delivered an era of ultra-low bond yields, its effect on economic recovery is less easy to determine.

However, investors continue to be convinced that equity prices are not overvalued even at record highs. In addition, they are also starting to better understand the interplay between stock prices and bond yields. Perhaps one year ago it used to be the case that the Fed could prepare to make its exit as the economy flourished under a period of easy money. Logic stated that beyond its bond purchase period the economy would be well enough primed to withstand a normalization of borrowing costs. The Fed, however, continues to pour cold water on that argument, leading investors to believe that interest rates will be lower than usual for longer, and that post-tapering will not guarantee that the economy is ready for policy increases. 

And so the backdrop for stocks in a gentle growth environment continues to look rosy. It would likely take the threat of recession and a slide in projected earnings growth to prevent the S&P 500 Index from stretching to as high as 2,100 throughout the remainder of 2014. Equally, the 10-year U.S. government note yield is likely to torment the strong bearish element among fixed income investors. Investors are slowly adjusting to the likely path of interest rates over time, and in the continued absence of inflationary pressures, it seems more likely that yields will touch 2.25% at some point in 2014 rather than returning to 3.03% where they started this year. 

Yields and prices move inversely. Rarely have bond prices correlated with those of stocks, except during the unprecedented era of quantitative easing at the Fed, and even then the relationship is hit and miss. Typically bonds go up in price when a recession is on the horizon. When the economic engines are finally ignited by loose monetary policy, stocks jump the gun and are quick to discount the more optimistic outlook, signaling a death-knell for bonds as yields are driven higher (see “Yields/curve slide in May,” below).  

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