Trader’s Narrative

The mad rush into US government treasury bonds has pushed their yields to never before imagined levels. But according to the simple 1 year rate of change, we may be close or have already seen the end of this “bubble”, as this long term chart shows:

Although I think the bond market will return to its senses soon enough, US government bonds are not in a real “bubble”. But the extra-ordinary demand for US treasury bonds is at least partially responsible for the strength of the US dollar. Which I’m sure itself is surprising and confounding the gold bugs more than anyone else. After all, how can a near meltdown of the world’s financial system result in gold falling and the dollar going up? Isn’t that the exact opposite of what a sane person would expect to happen?

This recent chapter in financial history is chock full of unprecedented extremes and “Black Swans“. Among them, the yield inversion between equities and treasury bonds (Bloomberg):

Something that we haven’t seen in 50 years. And something that was just as jarring when it was witnessed in 1958. The sharp drop in rates is half the explanation, the other half is the dramatic rise in stock dividend yields.

Most market watchers are perplexed about what this means, if anything. The only explanation offered which makes some sense comes from Cliff Asness of AQR Capital:

From the 19th century through the mid-20th century, the dividend yield (dividends/price) and earnings yield (earnings/price) on stocks generally exceeded the yield on long-term U.S. government bonds, usually by a substantial margin. Since the mid-20th century, however, the situation has radically changed. In addressing this situation, I argue that the difference between stock yields and bond yields is driven by the long-run difference in volatility between stocks and bonds. This model fits 1871-1998 data extremely well. Moreover, it explains the currently low stock market dividend and earnings yields. Many authors have found that although both stock yields forecast stock returns, they generally have more forecasting power for long horizons. I found, using data up to May 1998, that the portion of dividend and earnings yields explained by the model presented here has predictive power only over the long term whereas the portion not explained by the model has power largely over the short term.

More about the relationship between dividend yields and US treasury bonds:

John Mauldin: Two Little-Noted Features Of The Markets And The Economy
Bloomberg: S&P 500 Payout Tops Bond Yield, a First Since ‘58: Chart of Day
Barron’s: Reversal of Fortunes Between Stocks & Bonds
Mark Hulbert: Stocks vs. bonds