by Sean Keyes
Posted 18th November 2016
Yesterday, I said Trump’s election has persuaded bond investors to loosen up. Long term bonds have sold off, which means bond investors are taking a less cautious view of the future US economy.
Based on that, we can say bond investors definitely don’t think we’re stuck in the same low-growth, low-inflation rut we’ve been in for the last few years.
But we can’t say specifically what it means. It could mean high growth and higher living standards… or it could mean high inflation and lower living standards. At the very least, it’s going to be interesting.
Now, reading the bond market tea leaves is all well and good, but it begs the question – what does this mean for stocks?
The Fed model and its shortcomings
When assessing this Trump-related bond-selloff, lots of pundits would turn to something called the Fed Model. The Fed model is meant to show a clear relationship between stock and bond prices.
You hear about it a lot – the notion that “stocks are high because we’re in a low interest rate environment”. The Fed model is widely-used, and it sounds sensible. But I think it’s bunk.
The Fed model basically says that bond yields and stock yields are related. It says that when bond yields fall, stock yields fall. And vice versa.
(I know you’re probably not used to thinking of stocks in terms of yields. To get a stock’s yield, just divide the expected earnings over the next year by the stock’s price. It’s the inverse of the p/e ratio. That way you get an apples-to-apples comparison of stocks and bonds.)
The intuition behind it is very simple. It’s all about opportunity cost – if it’s possible to get a higher rate of return on bonds, I’m less likely to want stocks. This is why, supposedly, stock and bond prices move together. The Fed Model basically says: when rates are low, like they are now, stocks should be high.
The Fed model is clean and simple, and it seems to make intuitive sense. That’s a good starting point with any economic model. There’s a problem though.
The fly in the ointment
The problem is inflation. As I explained in yesterday’s article, bond investors hate inflation. Bond investors have “locked in” a fixed income stream, and when inflation goes up that income stream gets less valuable in real terms. Inflation causes a bond’s real yield to go down.
Stock market investors aren’t as worried about inflation though. If inflation goes up, stocks’ earnings will go up too. Inflation doesn’t change stocks’ real yield.
In other words, comparing the yield on stocks to the yield on bonds isn’t apples to apples. Inflation gets in the way.
The Fed Model says you should buy stocks when interest rates are low. But according to research by Cliff Asness based on the period between 1965 and 2001, stock market returns in the ten years after interest rates are at their lowest tend to be pretty bad. So much for the Fed Model.
Where does this leave us when it comes to Trump and the stock market?
Well to be honest, you’re no wiser about that than when you opened this email. You don’t know what the bond selloff means for stocks because there isn’t a direct relationship between the two. But at least you know to be sceptical of all the people who say otherwise.
Plenty of companies will benefit from Trump’s reign. I’ll be looking at them in the coming weeks and months.
Have a great weekend!
P.s. I have a hunch about what’s happening in the US bond market. It’s a bit too wonkish and speculative to write a whole piece about, so I’m going to shove it in here as a P.S.
Because long term bonds are selling off, we know markets expect nominal GDP to be higher in the long term.That could be because a) the economy is going to grow a lot faster or b) inflation is going to be higher.
Let’s assume the market is right and NGDP is going to be higher in the long term. What’s that got to do with Trump?
We have a rough idea of Trump’s plan: eye-waveringly huge tax cuts without much detail on spending cuts. In other words, big government deficits.
The charitable interpretation of is that deficit spending will stimulate the economy in a Keynesian fashion, leading to a bigger economy, and higher NGDP. Hence the sell off in long term bonds.
I don’t buy that, because I don’t believe Keynesian stimulus actually works.
(Specifically: I think the central bank just compensates for deficits, which cancels them out. But I won’t get into that now, we’re already in the weeds. Let’s just assume that Keynesian spending doesn’t boost growth.)
So here’s my guess at what’s happening: Trump is going to run huge deficits (over ten years, his planned tax cuts would add $5.3trn to the national debt, making it 38% bigger). Adding $5.3trn to the national debt makes inflation a bit more likely. Hence the bond selloff.
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