Stocks and bonds continue to be diametrically opposed, as stock investors believe stock prices are going to continue rising for another decade, while bond investors see zero percent interest rates on the horizon. Both sides cannot be right. Based on the design of our monetary system, when stocks rise, so should bond yields, and when bond yields fall, so too should stock prices. In what has become the largest divergence between stock prices and bond yields, only one can be right.
It seems strange that stock indices tend to hit round numbers when there is no actual reason for it, other than humans find round numbers easier to comprehend. Stock prices are rising because enough people believe stock prices should be rising. After all, the economic data, the monetary data, and even corporate profits suggest otherwise. When enough people believe stock prices should rise, they do, until people stop believing and start selling.
Investors today see similarities between President Bush and President Trump, which should not be a surprise since President Trump followed a similar campaign strategy. Baby Boomers remember the unprecedented economic boom that followed in the 1980s, and they believe we are on the cusp of another multi-decade rally in stock prices.
The Boomers are watching the younger versions of themselves, or the Millennials, enter the workforce and are expecting an economic repeat of the greatest Bull market in history. The Millennials are unlikely to experience the same economic boom as their parents did since they are entering a very different economy than their parents did. Yet, it has not stopped enough people from believing that stock prices are headed higher, so stock prices will continue to go higher until fewer and fewer people believe.
On the other side of the market are those who do not believe this economic boom is real and that just like during the last two recessions, the economy and stock prices are headed for a major recession, or worse, depression. To profit off their view, these investors have turned to U.S. Treasury bonds and other safe assets to protect themselves from the ensuing deflationary crash that comes when asset bubbles burst.
On the side of stock investors are corporations, who are buying back a record number of shares, computer algorithms, who think any news is bullish for stocks, retail investors, who always buy high and sell low, and large money managers, who are forced into taking risk to generate a positive return for their clients.
On the side of bond investors are large commercial banks, who are buying billions of dollars worth of bonds each week, the “Smart Money,” who is always on the rights side of any market, foreign investors, who experience an economic downturn before it hits U.S. shores, the Federal government, who is running large fiscal deficits, and the Federal Reserve, who is going to burst the bubble by tightening monetary policy and who is quietly unwinding long-term U.S. Treasury bonds from their balance sheet.
Either stock investors or bond investors can be right and while there are brief periods where both sides can be right, both sides cannot be right indefinitely. At some point, either bond investors will capitulate by selling their bonds to buy stocks, or stock investors will capitulate by selling their stocks to buy bonds. While the gap between stocks and bonds may persist for a while and further widen, one side will be wrong. Investors on the right side of the market stand to make a hefty profit when the other side is forced to sell.
The probability that bond investors are right is high since they are more frequently right than wrong. When an investor buys a bond, they tend to hold it for a longer period than they might be willing to hold a stock. Stock investors on the other hand, frequently short bonds to get more money to buy stocks.
To short a bond, an investor borrows the bond from a securities dealer and sells it on the open market. The investor owes the securities dealer the dividend on the bond since the securities dealer is the rightful owner of the bond, even though it was sold to another investor. Should interest rates rise, and bond prices fall, the investor who shorted the bond can go out to the market and rebuy the bond at a lower price to profit on the difference. Should interest rates fall and bond prices rise, the investor who shorted the bond can be forced to buy the bond back at a higher price to repay the securities dealer.
When an investor is forced to buy a security back, or in this case a bond, it is referred to as a short squeeze. A short squeeze occurs when the investor who sold the security, or bond, is forced into buying it back to either minimize their losses or cash in on their rapidly shrinking profits. Bond investors do not short stocks to buy bonds, which is why there is rarely a short squeeze in the opposite direction.
While belief in stocks is helping stock prices go higher, stock investors cannot ignore the declining global economic data forever. Investors are celebrating the June payroll report that beat expectations, but it is likely the last good payroll report for some time. When financial conditions tighten, businesses will reduce their profit margins in hopes the economy turns around, but when it does not, they begin to layoff.
Small businesses, with less than nineteen employees, are starting to shed jobs according to the recent ADP payroll report and the automobile sector is planning on large layoffs in the coming months as vehicle sales slow. According to the Household Survey, the labor force has lost 600,000 jobs since December. While the headline Nonfarm Payroll report has shown a healthy increase in jobs this year, if it was not for the fictitious self-employed jobs the BLS creates every month, the payroll report would not show any gains since February.
The Fed is about to get trapped in its own monetary policy as large investors have been selling stocks to raise cash, as evident in the weekly M2 Money Supply data, which has been showing a steady increase in cash holdings since late last year. The Fed is still reducing the Monetary Base as part of its balance sheet unwind, which is scheduled to stop by the end of September. The problem for the Fed will be a sudden, and unexpected, burst of consumer-price inflation.
Consumer-price inflation is likely to rise since the Money Multiplier, which is algebraically expressed as by the M2 Money Supply divided by the Monetary Base, is rising. When the M2 Money Supply rises at the same time the Monetary Base falls, as it is now, the Money Multiplier rises. The significance of this relationship is that consumer prices tend to rise and fall with the Money Multiplier.
The problem for the Fed is that consumer prices are going to rise during a period of tight financial conditions. Stock investors are hoping that financial conditions will ease to justify higher consumer prices. Meanwhile, bond investors are hoping that consumer prices fall to justify tighter financial conditions. Since the Fed bases their monetary policy decisions on the annualized change in consumer prices, the Fed may not be able to ease financial conditions without fear of inflation running rampant.
When consumer prices rise during periods of tight financial conditions, corporations begin to layoff, which leads to stagflation. Stagflation is any period of high unemployment and rising consumer prices. Should the Fed target unemployment, then they will fear further increases in consumer prices and if the Fed targets rising consumer prices, then they will fear increases in unemployment. Stagflation is a central banker’s worst nightmare, and it is likely coming soon.
The Fed must ease to reduce the Money Multiplier by increasing the Monetary Base, which can be achieved by lowering the Federal Funds rate and through Quantitative Easing. The bond market has figured out the Fed will not be able to ease since consumer prices are likely to follow the Money Multiplier higher. In the strange world of monetary policy that we live in today, easing is disinflationary and tightening is inflationary, which is the exact opposite of how the Fed expects monetary policy to affect consumer prices.
The bond market has figured out the Fed has made a huge policy mistake, but stock investors have yet to accept this. Stock investors believe the Fed can ease financial conditions and cause stock prices to rise, when further easing at this point, will have the opposite effect. In the end, only stock prices or bond prices can be right, and in this case, bond investors will likely be proven right once again.
The Fed is Backstopping Bonds and Europe is a Mess (07/08/19 – 15 min)
Time to Buy Gold? (07/10/19 – 17 min)
Weekly Economic Update 7/12/19 (07/12/19 – 30 min)