The story for the past week or so has been about how the surprise Brexit vote ravaged the world’s financial markets, sending investors running for cover.
It might seem a moot point in the U.S., as large cap indices like the Dow quickly came back to within a few points of their pre-Brexit highs.
The bond market, however, is telling a different story…
While Britain’s vote to exit the European Union has come and gone, the exit itself – and all the uncertainty surrounding it – won’t be sorted out for maybe a couple years.
Already, the Bank of England (BOE) is bracing for trouble.
Yesterday, the Bank’s Financial Policy Committee eased reserve requirements for banks. This just means that in a potential crisis, banks will have a greater ability to lend.
After that announcement, yields tumbled again and made new all-time lows.
Clearly, the Bank of England is preparing for the possibility of a downturn in the near future.
But bad news is good news for the stock market. When talk of a downturn arises, investors expect more central bank stimulus to carry the market higher. And that’s what the market’s anticipating ahead of the Bank of England’s monetary committee meeting. So too with the ECB, and maybe even the Fed.
Treasury bonds, on the other hand, aren’t buying the “all is well” scenario just yet.
Yields made historic lows late last week and again yesterday. Even though stocks rebounded, those investors who moved to safety aren’t moving out of long-term bonds.
Take a look at the chart comparing the S&P 500 to long-term Treasury yields over the last couple weeks. What’s really interesting is what happened after the Brexit vote:
As you can see in the chart above, stocks moved lower and piled into bonds following the vote. But after the markets sniffed more central bank stimulus, stocks and bonds decoupled.
There is usually a pretty high negative correlation of stocks to bonds. When stocks move higher, bond prices move lower and yields go higher.
But the way stocks and yields have diverged over the past week shows we’re not out of the woods just yet. Investors are still feeling the jitters. In fact, stocks have been slumping again after rebounding most of last week.
Even some encouraging data over the past week couldn’t shake the markets of their fear.
Last week, the final adjustment to first quarter GDP was a little better than expected, with residential investment being a big contributor.
May Personal Income and Outlays, another the Fed watches very closely, was mostly positive. Consumer spending came in strong again, but personal income didn’t rise as much as expected. The Fed’s main inflation guide was unchanged across the board.
All in all, the recent data’s been decent. But instead of all that, the markets are focusing on the likelihood of new central bank easing – and any reason they have to turn on the stimulus spigots.
Take Friday’s upcoming jobs report, for example.
Last month’s pitiful report stopped any thought of a rate hike in its tracks. The economy added just 38,000 jobs after expecting 162,000. Another report like that will probably get the Fed talking about some possible action. Conversely, a surprise surge in jobs or wages would be a huge comfort. So we’ll see what the Fed does or says after Friday.
But even if they decide to act, I doubt it will make much of a difference.
On Bloomberg T.V. last week, James Bullard, the St. Louis Fed President, said the Fed has plenty of policy tools to use if necessary (compared to other central banks).
He actually cited forward guidance or Fed jawboning as an effective tool! He also mentioned additional QE as a possibility and downplayed negative rates.
I about fell out of my chair when he said that!
He admitted that just “talking” about future policy is a tool they can use to manage sentiment and run the economy. He flat-out confessed that the Fed’s all talk!
But that’s what global equity markets are counting on – more talk – and why stocks have shot higher over the past week.
They all think stocks will get a boost when central banks announce new or potential rate cuts, bond purchases, or even just talk about it. Bond traders are also looking to capitalize on the safety of Treasury bonds, since falling yields will give them huge capital gains.
The problem is and has been the same.
Central bank policy has kept the financial markets afloat but for most people has failed to turn the economy around, spark employment and wage growth, or battle deflation.
So when the dominoes start falling, companies start failing, recession hits, and real crisis strikes, it will finally be game over for central bank manipulation.
Editor, Treasury Profits Accelerator