Tag Archive: bonds

Reviewing current stock vs bond sentiment

Despite what you might hear or read some places, investor surveys do not show an extreme level of optimism toward US stocks. Bullishness on stocks has in fact declined somewhat recently and is not far from long-term average readings.

Sentiment toward bonds, by contrast, has moved quite sharply and is now approaching extreme bearishness by the standards of recent years. This is not too surprising, given that long-term Treasury bond yields have recently risen to their highest levels since COVID hit early last year. The result has been that investors in long-term (20+ year) Treasury bonds have lost about 13% since the end of November and about 18% since the end of July.

One of our key measures of survey sentiment for equities is shown in the top section of the chart below. It is an average of several sources, each of which monitors the proportion of market commentators who are bullish or bearish on equities. They include Investors Intelligence, Market Vane, and Consensus Inc.Stock vs Bond Sentiment

Source: Mill Street Research, Investors Intelligence, Market Vane, Consensus Inc.

The average proportion of bulls on stocks right now is about 60%, down from a recent peak in January of 67%.  The average proportion over the last five years has been just over 57%, so the current reading is only slightly above average. The peak in the last five years (and in fact since at least 2003) was at 76% back in January 2018 (when the corporate tax cuts were going into effect), while the lowest point in the last five years was the brief reading around 33% in late March of last year amid the worst of the COVID-related panic. Readings below 50% on this metric are relatively rare outside of panic periods.

These survey readings stand in contrast to other sentiment-related indicators like put/call volume ratios, certain valuation metrics, or anecdotal “indicators” like the popularity of SPACs or the extreme behavior of “meme stocks” with heavy retail trading activity. Other market-based measures of risk appetite (e.g. relative performance of riskier stocks) suggest investors are still broadly in a “risk on” mood.

Sentiment readings that are not extreme in either direction tend to give less information about future returns. But we can certainly see that stocks have often done well when sentiment has been near current levels, as sentiment has been around these levels since August . Extreme bearishness tends to be the strongest signal for stocks, but occurs relatively rarely given the long-term uptrend in US stock prices.

The negative sentiment toward bonds suggests that the recent rise in bond yields may be getting somewhat stretched. If investors continue to assume that the Fed is not changing its current policy guidance and will keep short-term rates near zero for at least the next year or two, then long-term yields may not have too much further to rise.

Taking the next step, if equity investors are growing more concerned recently about risks that higher bond yields may cause regarding the level of stock prices (i.e., a higher discount rate reduces the present value of future earnings), then sentiment toward bonds is worth watching as part of the broader picture facing equities.

Bond market making some noise

The bond market has clearly awoken from what appeared to be a low-volatility Fed-induced slumber for much of last year. Longer-term bond yields in the US and elsewhere have jumped to their highest levels since just before the COVID crisis hit markets early last year (blue line in first chart below). Even after this rise, though, the 10-year Treasury yield remains below even the low points of previous cycles.

Short-term rates (0 to 2 year), meanwhile, have remained anchored near zero due to the Fed’s continued indications that any policy rate hikes are still at least two years away.

US Treasury Yields

There are two main components to Treasury yields (which do not have default risk): real yields (yield after subtracting expected inflation) and inflation expectations. The first component to move was inflation expectations (first chart below), and more recently real yields (second chart below) have also risen notably. However, real yields remain solidly negative and much lower than they were before COVID-19 hit last year.

Breakevens 5yr 10yr

Treasury 10-yr Real Yield

What have been the drivers of the recent move higher in long-term bond yields?

Some of the most prominent reasons include:

  • Additional fiscal stimulus is expected soon, which will potentially boost inflation and growth, and also require the issuance of a large amount of new Treasury bonds.
  • The economy’s recovery from COVID-related weakness is continuing thanks to ongoing vaccinations, which will combine with stimulus to push growth much higher than average this year.
  • Sharply higher prices for oil and other key commodities (copper, lumber, etc.) are raising concerns about inflation already in the pipeline, with further demand potentially driving prices even higher.
  • Selling or hedging activity by investors who trade leveraged positions in bonds, and/or own mortgage-backed securities that now appear riskier. Rising mortgage rates typically reduce pre-payments (due to less housing turnover) and refinancing of home mortgages, which increases the duration, and thus risk, of mortgage-backed bonds.

The jump in market-implied inflation expectations has been quite sharp, though something similar happened after the 2008 crisis period as well. The current inflation expectations reflected in 5-year and 10-year Treasuries (difference between nominal Treasury yields and inflation-protected TIPS yields) are now slightly above the Fed’s 2% inflation target. Indeed the 5-year implied inflation rate (breakeven rate) is at its highest level since 2013, and the 10-year rate touched its highest since 2014. Investors now appear to expect a rebound in inflation, which is likely not considered a problem by the Fed (given their stated inflation goals) as long as expectations do not become excessive. However, the Fed’s own buying of TIPS in the past year may itself have skewed the interpretation of “market expectations”: the Fed now owns well over 20% of the entire TIPS market, potentially influencing their prices (yields) more than usual.

For stock prices, a moderate amount of inflation is not necessarily a bad thing for corporate earnings, as long as it does not provoke Fed tightening. Since equities (via corporate profits) are partly hedged against inflation, real yields are often viewed as the more important rate. Thus the recent rebound in real bond yields has raised concerns about equities losing the tailwind they have had from falling real yields for more than two years. It has also provoked a shift in investor interest from Growth stocks that are attractive when economic growth and inflation are low toward Value (and other riskier) stocks that tend to do better when economic activity and inflation are accelerating.

With short-term yields still pinned near zero by the Fed, the yield curve has steepened sharply recently. This is notionally good for Value-oriented banks and other “spread lenders” (who borrow at short-term rates and lend at long-term rates), though many other factors can affect the profitability of lending, and higher rates can dampen loan demand.

And one of the biggest impacts of higher long-term yields is in fact on mortgage rates and thus the housing market. Housing has been an extremely hot area recently, as demand for single-family homes is very high and supply has been unusually low. The average 30-year mortgage rate recently hit an all-time low of about 2.8% but has now jumped back up to 3.14% in just the last two weeks (and will likely rise somewhat further near-term). While this is still very low by historical standards and may not hamper housing too much, at the margin it may cool demand, and any further increases would put additional pressure on housing demand.

Overall, a moderate rise in long-term yields with well-anchored short-term rates is not necessarily a major cause for concern for stocks, or the economy, in general. It does however mean potentially more rotation among sectors and styles within equities. It will also bring up concerns about whether or when the Fed will decide to alter its current policy trajectory in response, as too much of a rise in yields could cause economic dislocations that the Fed would prefer to avoid.

Risk on? Not really since early June

In financial markets, it seems like “everything” is going up recently. Stocks, bonds, precious metals, even Bitcoin. Perhaps that should not be surprising given the huge amount of liquidity being produced by global central banks in addition to the fiscal stimulus earlier this year. That tends to have the effect of pushing asset prices up generally.

But when we look at relative returns of some key assets, it looks more like the “risk on” trend has not really gone anywhere since early June. That is, owning the riskier option within various asset classes has not generated excess returns to compensate for that extra risk since the recent peak in risk about June 8th.

As shown in the chart below, buyers of risk in many areas have not been rewarded for about two months now (shaded area since June 8th). Brief comments on each section of the chart are below it.

This could be a natural consolidation after a surge in return to risk after the late-March lows, or a sign that the impact of stimulus, and stimulus itself, is fading.  Many prices/valuations are back near pre-COVID levels even while the economy and earnings are still far weaker than they were in January. Uncertainty about additional fiscal stimulus, now that much of it has expired or been spent, and worries about the continued aggressive spread of COVID-19 in the US are potentially countering the positive hopes for vaccine developments and ongoing central bank support.

We will be watching these returns closely for indications of whether investors are getting properly “paid” for taking on additional risk.

High vs Low Risk Relative Return Measures

  • Top section: Global stocks, measured by the MSCI All-Country World Index (ACWI) have performed no better than long-term US Treasury bonds since early June, and are still far behind bonds on a year-to-date basis.
  • 2nd section: Similarly, within the fixed income market, long-term Baa-rated US corporate bonds have done no better than long-term US Treasuries since early June (despite the ongoing support from the Federal Reserve), and remain well behind Treasuries for the year-to-date.
  • 3rd section: High-beta stocks in the S&P 500 have lagged low-volatility stocks in the index since early June, even as the S&P 500 itself has moved somewhat higher.
  • 4th section: US small-caps have lagged large-caps since early June, and small-caps remain significantly more volatile.
  • Bottom section: Among commodities, industrial metals (copper, aluminum, zinc, etc.) that are used in manufacturing are typically a measure of global growth that rise when the economy is improving (“risk on”). Precious metals are more often preferred as an inflation or currency hedge (“risk off”). So while both industrial and precious metals prices have individually risen significantly recently, industrial metals prices have lagged those of precious metals since June.