Cast one’s mind back three years to 2013. The S&P 500 index posted an intraday high of 1,849.44 and closed on December 31 at its best level of 1,848.36. The equity market did retreat by 4% in January 2014, however, before resuming its march to higher levels.
In a similar vein, the 10-year US Treasury bond closed the year at 3.026% before pushing lower once again.
The S&P 500 closed on July 12 at 2,152.14, and the current yield on the 10-year US Treasury is 1.473% (as of 13:21 BST).
The driving force behind the aggressive rise in equities and decline in bond yields is to be found in the fact that the Federal Reserve has been acquiring hundreds of millions of US Treasury securities as the key element of its quantitative easing programme.
This was driven by the Fed deciding that the economy needed a massive level of support through an ultra-easy level of accommodation that would stimulate general economic activity.
At the midway point of 2016 there is every expectation that the S&P 500 may close at a record high above 2,130 at the same time as the 10-year yield closes at a record low beneath 1.36%.
Source: NYSE, Spotlight Ideas
Source: US Treasury, Spotlight Ideas
The difference between three years ago and the present is that although the Fed has kept the effective overnight lending rate near 0.00%, it has tapered down its QE programme of acquiring US Treasuries. It has throttled back away from "full steam ahead" on the stimulus front.
When this author first started in the City, the general rule was that bad economic data helped bonds rally and torpedoed equities. So to have both the S&P 500 pressing toward a new record high and the yield to maturity on the 10-year US Treasury decline toward a record low has shown that financial theory has been turned on its head.
It is not the first time such a phenomenon has been seen as the data records show a similar confluence of index levels and bond yields happened some 40 years ago (before my time!).
Can equities and Treasuries keep improving?
Since the equity market suffered a correction in February – the S&P 500 closed on February 12 at 1,864.78 and the S&P VIX soared over 28 – both equities and investment grade debt assets have performed remarkably well. However, bonds have shown far less volatility than equities.
What is a worry is that, as any observer of financial market history will know, this trend cannot continue for ever. Something will turn, i.e. the bond or equity bubble will burst. Heaven help us if both asset classes are deflated simultaneously.
That is not so likely at the front-end as over the past five years the level R-Squared between the S&P 500 and the two-year US Treasury is 0.7137, whereas since February this year it has fallen to just 0.2638.
However, move that analysis to correlate the S&P 500 and the 10-year US Treasury and then you find the level of R-Squared for five years is 0.5757, lower than the short-dated debt, and yet since February of this year the correlation only is stronger at 0.4746.
Market optimists argue that this strong correlation between equities and Treasuries will expand to embrace all investment grade bonds and will persist for at least the rest of the year. They underpin this view by believing global capital from the institutions, pensions, sovereign wealth funds, money managers, and retail is set to continue to be attracted by US stocks and debt down to single A, where a positive yield is available.
Positive yielding debt has become increasingly scarce with $12 trillion in negative yielding global debt underlying the extent of the flight to quality. It is also argued that even if equities carry a high P/E ratio, the fact that they have a positive yield makes them attractive alternatives to low or negative yielding debt.
The counter argument is that the risk off factor is becoming more powerful with rise in equities and decline in yields.
Look at the global scenario: there is a collapse in the once-ebullient BRICS' confidence as China looks fragile, Brazil is mired in corruption, and Russia reels from lower oil prices. We wait to see what solutions prime minister Shinzo Abe has now in Japan following his new mandate and the UK has left the European Union, which itself is an economic mess.
Away from the sovereign aspect, Italian and Spanish banks are creaking and so in sum we are really staring at a tricky world environment of unprecedented global uncertainty and headwinds.
Just another day in 2016. Photo: iStock
— Edited by Michael McKenna