It is said that there are eight million stories in the Naked City, some more naked than others. The one about yields putting a lid on stock growth is about as naked as they come.
We always have our eyes open to what is happening in the financial world, which includes looking at what other people think is happening or think might happen. There is no shortage of that sort of thing, and while a lot of this banter doesn’t really stand out that much, sometimes you run into an idea that you would never even have thought of.
While people are worrying about our bull market ending for a number of reasons, some which may have more merit than others, financial columnist Randall Forsyth believes that one of these is bond yields putting the lid on stocks, which definitely commanded our attention due to the utter strangeness of such a claim.
While there is an interplay between the stock and bond market, we immediately wondered how such a thing was possible, and this had us delving into the article and the reasoning behind it to find out. This was at the very least going to be a more interesting journey than most, and even if the claim turned out to be built on mud, as we always say, there’s even some insights to be had by looking at the bad ones if you do so with your eyes fully open rather than just reading passively.
Forsyth has been writing these things since back in 1982, and we can assume that don’t write financial articles for 38 years and not have at least an elementary understanding of bonds. Still though, a bull market that gets halted by rising bond yields? This all seems so crazy on the face of it that we had to explore it further.
If this were a risk, we might not want to buy bonds on account of this, but we might want to at least have our hands on our guns should this bizarre event start showing its ugly face and stick its tongue out at us. On the other hand, if this monster turns out to be based upon mere fantasy, we at least can take you on another little walk down Bond Lane and provide some insights to shed some more light on this dimly lit alley.
We need to start by pointing out that this is not about the bond market getting hot enough to suck so much money out of the stock market that this depresses stock prices or even inhibits their growth. This sort of thing can at least happen in theory, even though when we see money flow from stocks to bonds it is always because stocks are suffering and bonds may become more attractive as a result, and not the other way around.
Of the two asset classes, stocks are going to be preferred in the aggregate normally among investors because you normally make a lot more money from stocks. When stocks don’t do so well, people will indeed sell stocks and buy bonds, and they even will do this when stocks are moving ahead nicely like they are now. We saw record levels of this bond buying last year and we had one of the better years with stocks ever.
This does serve to dispel the notion that the two cannot go up together like this, given that 2019 was also one of the best years for bonds. Any move from stocks to bonds certainly did not put us down this time, and the reason is that stocks require their own reasons to go down, and the bond market cannot possibly heat up enough to provide returns that could ever trump a bullish stock market.
In spite of how much bonds increased in value last year, a year for the ages even, stocks provided over 4 times more return, so this is wrestling with a much bigger opponent that at least has to be injured for bonds to take down. If record levels for bonds can’t lay a hand on stocks, this won’t tackle our current bull in 2020 either, or ever, as long as the bull is running.
When our bull does stop charging ahead though, it will be the wall that it runs into that stops it. We hit a big wall in 2008 for instance and it took a few years of rest and recovery along with the best care government could provide to get stocks on their feet again.
It wasn’t the bond market that did this or even contributed to it of course. Stocks go down because investors get bearish on them, and there are a number of causes, including things like the recession we got thrown into back then. We saw a massive overselling of stocks, and the rebound that ensued is how our current journey upward was born.
We Already Had an Extremely Good Year for Bonds Last Year, With No Slowdown in Stocks
It wasn’t only that bond prices approached record levels last year, we also had record inflows into bonds from retail investors helping to drive it, in a way that even surpassed times when people actually fled from stocks and into bonds during stock market crashes. Investors also put a lot more money into bond funds last year than they did in stock funds, and we even saw a net withdrawal from stocks and a big inflow of cash into bonds, but the stock market not only kept going up but moved up even faster.
This should tell us pretty clearly that this is not a reliable way to understand the situation at all. If this was all Forsyth was claiming will happen, we at least could put this on the side of theoretically possible, but what makes his claim so utterly bizarre is that he is claiming rising bond yields will be the impetus, taking us clearly into the land of contradiction.
The bond market and yields are inversely related, so yields go down when bonds get bullish, and yields increase when bonds become bearish. They were very bullish in 2019, with a corresponding big drop in yields.
Yields going up requires people to be bearish on bonds, not bullish. This is simply a matter of supply and demand. For some unknown reason, some people think that bond yields are not determined by the market, and instead by external forces such as inflation, and forget a step here, the fact that things like inflation influence bond demand, and inflation does its dirty work by reducing the demand for bonds, which results in their prices declining.
If bond yields go up, this only means one thing, and something we know with certainty, which are that demand for bonds has decreased. You can’t have bond demand increasing and bond yields going up together, as this is an impossibility.
If bonds became so attractive that they would cause such an outflow from stocks that this would be, in Forsyth’s words, a “looming stock market killer,” this would require bond yields to sink much lower than they did in 2019, a year that the stock market simply laughed at bonds. Perhaps there are people out there who think that bonds can independently smack stocks this way, perhaps by having enough people confused enough about such things, but this would require such a massive exodus out of stocks and into bonds to make it comparable to aliens flying in and taking control of the Earth.
To imagine this happening as bond yields climb, which Forsyth suggests, is just ludicrous, and is certainly a strong candidate for the most naked story in the city ever. Bonds do tend to confuse people a lot though, even those who are supposed to know what they are talking about, so perhaps we should not be quite as surprised as we are to read such a thing.
Rarely, yields can go up notably while stock prices sink, but this requires a significant recession. People aren’t flocking to bonds in this scenario, they are running away from both bonds and stocks, which we saw during the Great Recession for a time. We cannot claim that the stock crash was caused by bonds in any way though, or even that bonds were involved in any way, as the outflow from stocks did not even go there.
Sometimes it does though, in bear markets, where people get sick of seeing their stocks go down and move more to bonds. Since such a thing increases demand for bonds though. It puts yields down, not up.
Forsyth starts his article by telling us that “the bond market has been the stock market’s best friend in its run toward Dow 30,000.” That’s a very interesting comment right there, since stocks surely would have done better if bonds haven’t been running so hot, where we would have seen even more upward pressure on stock prices due to this extra money raising demand even further.
Forsyth tells us that this alleged boost to stocks was due to lower yields with bonds making stocks more attractive, but if this were true, we would see people putting more money into stocks and less into bonds. It does not seem to bother him that the exact opposite has happened.
We may then wonder how someone could even come up with such a view, and it seems that he thinks that the bond market is comprised of old people in retirement who are just looking for income. This market is far larger than that, and most of the money that goes into bonds prefers yields to go down not up, and this even includes all those retirees, whether they know it or not. Their investments go up in value when yields decline, every time, no matter how much they may shake their fists in ignorance.
Even retail investors haven’t been turned off by lower yields, and quite the contrary, they just put record amounts of money into bonds. We’re marching ahead not because of this but in spite of this, although when we add in the expectation of bonds cooling off in 2020, now we have the potential for this to help stocks a little. Forsyth’s perspective is inverted towards reality in the same way as bond prices are inverted toward yields.
This Might All Make Sense in a Different Universe, But Not in This One
He then turns to what appears to be the crux of his argument, that there may be something unknown bubbling below the surface that may cause inflation to rise a lot in 2020, which presumably will raise bond yields enough that bonds will somehow become seen as so much more attractive than stocks to investors that it will halt the advance in the stock market that we’re seeing.
While people worry a lot about inflation, we’re at a time where we wouldn’t expect anyone to be worried about this too much now, although there are 8 million stories in the naked city so seeing one of them tell this story perhaps should not be all that surprising. He even paraphrases Mark Twain by telling us that the death of inflation may be greatly exaggerated, which at least adds a little more color to his fairy tale.
If inflation does somehow rise up like the Frankenstein monster out of nowhere, this in itself will stop the rise in stocks cold. We don’t even have to worry about whatever influence the bond market will have on this, because this will see the Fed step into the street with guns ablaze and this will put an end to the party as sure as the sun rises. Inflation only crept up a bit beyond the Fed’s liking in 2018, and a few well-placed shots was all it took to shoot stocks down quite a bit for a time.
However, it’s interesting enough that someone would think that bonds would or even could be the culprit in this far-fetched drama even though this would both cause stocks to drop and put yields up. We can’t forget that this all means that money will be coming out of bonds, not into them. The reason why inflation causes bond yields to go up is because this hurts bonds and they are worth less as a result, making them considerably less attractive, not more, with less money invested in them, which we know is true with certainty.
Any exodus from stocks to bonds places upward pressure on bond prices and downward pressure on yields in turn, but whatever effect we may see here becomes completely overwhelmed by the downward pressure on bond values that inflation causes. Inflation is the enemy of both stocks and bonds, and bonds suffer the most when inflation rises.
Inflation can therefore be a big worry for all investors, although they often do not understand it and many even get fooled by thinking that higher bond yields are a good thing when they hold bonds, and a lot of people indeed are confused by such a thing.
We know for sure though that if inflation rises from the dead as Forsyth fears, bonds will take a hit and a bigger one than stocks will. To even suggest that all of this is a reason to look away from stocks and more toward bonds right now is horribly confused, and to make matters even worse, this is not a good time to be in bonds with or without the sky falling, due to yields expecting to rise.
Even if they put something in the water to cause us to buy this story and we all move a lot of money into bonds from stocks, to a level far in excess of what we did last year, this might put stock prices down for a time, but put bond yields down further. Since so many people buy bonds to seek yields, and this is supposed to be the idea behind this rationale, yields moving in the other direction would soon have even the dimmest of investors seeing the error in their thinking.
Stepping back into the light of day, we see the march toward Dow 30,000 continuing unabated, and high inflation still far away. While there are a number of things that could prevent us from getting to 30K, it is not even possible that rising bond yields could in themselves stop this, in this particular universe at least.