May, what have you done?

 How can the month bring on record highs in the stock market and lower yields in the bond market?  Are not bond yields supposed to go down when stocks rise – remember “risk on” and “risk off” a la Mr. Miyagi of “The Karate Kid.”  In what parallel financial market do we now find ourselves?  Perhaps we can shed some light on the matter and offer some possible explanations.

In an article that appeared in Financial Sense, author Chris Puplava examines the strength of four explanations for bond markets improving, and we tend to agree with him.  The four possible explanations are:  concern over on-going tensions between Russia and Ukraine, fear of slowing US growth, a sudden rise of foreign buyers of US treasuries, and the belief that the Fed will continue to keep rates increases on hold well into 2015.  Let’s take a deeper look into each.

Geopolitically, we are keenly aware of the unrest occurring in the Ukraine.  While no one knows how things will end, we do know how markets closer to the danger are reacting to the situation.  If a single country could serve as an indicator of the risk of escalation, it would be Poland, Ukraine’s neighbor to the west and a country with historical sensitivity to Russian aggression.  If the conflict in Ukraine was poised to have an economic impact on Poland, it would be reflected in falling bonds and stocks.  However, Poland’s bonds are higher since the conflict began, and its stock market and currency are roughly flat for the year.  This and other evidence from the region suggests that events in Ukraine do not explain the downward move in US bond yields.

Let’s turn our attention to the US and its economic growth.  Is the bond market simply ahead of the stock market in recognizing that bad news and slow grow are on the horizon?  We don’t think so.  We are continuing to track leading economic indicators, and we have observed a solid, broad-based rebound in multiple measures of manufacturing and services, employment, consumer optimism, and even some positive data on the housing market.  Also, several regional Federal Reserve Banks are reporting that businesses are experiencing significant increases in prices paid for inputs, which would reflect the beginning of inflationary pressures, should they continue to rise. All of this suggests that bond yields should be rising rather than falling.

The idea of foreign buyers increasing their purchases of US bonds is a bit more complex.  Since the height of Europe’s sovereign debt crisis (recall Greece’s near default and similar troubles in southern Europe), European bond yields have come down dramatically, reflecting both a reduction in risk of owning European bonds and, more recently, slower than expected economic growth in Europe.  Faced with deflationary pressures (see January’s “Notes”), the European Central Bank (ECB) is beginning to consider economic stimulus, ranging from lowering interest rates to charging banks for their excess reserve deposits to out-right bond purchases.  While such measures should stimulate the economy, they also lower interest rates and weaken the currency.  US treasuries become attractive to foreign investors in two ways.  The first and easiest to understand is that US bonds offer 1% more than corresponding German bonds.  Add to that the expectation for a weaker Euro, and US bonds priced in rising dollars begin to look great to foreign investors.  The attraction of higher interest rates and a rising currency to foreign buyers makes this is a very credible explanation for US bonds yields going lower.

And finally we have markets responding to our very own Fed, which has been reassuring them that rates will stay lower for longer, following Yellen’s comment earlier this year that the Fed may begin raising rates by mid-2015.  Markets are being convinced, with interest rate expectations falling.

We agree with the conclusion that declining US bond yields are not foretelling a recession, but are the result of buying by foreigners and Fed assurances.  Indicators of economic growth do not suggest a recession is near.  As a finance professor once said, when asked why the markets were up: “It’s simple.  There are more buyers than seller!”  That seems to be the case for both stocks and bonds at this point.

As always feel free to call us with any questions or concerns.

Regards,  Erik David and Frank