Contrary to conventional wisdom, the equity & bond markets are telling us exactly the same story

One of the biggest topics these days is the divergence between a very bearish yield curve and a very bullish equity market. The latter has staged a muscular 19% rally since its Dec 24th low, while the former declined 14% in the same time frame.

Conventional wisdom in the investment community is that a declining rates is an harbinger of economic weakness while raising equity rates are typically associated with higher future earnings and, typically, the hallmark of a growing economy. Hence the disconcert of market participants left wondering which of the two indicators is correct and how to adjust their investment strategy.

The key to understand that both bonds and equities are driven by the same narrative, is to come to terms with the fact we live in a world where asset prices are now primarily driven by government policy.

More than a decade of massive monetary and fiscal stimulus have contributed to “zombify” increasingly large segments of the global economy, hence preventing the fundamental process of “creative destruction” which is at the basis of any healthy system. Rather than bringing the economy to “escape velocity”, such policies have only succeed in increasing the stock of debt and inflating asset prices.

As we have been able to observe in Japan first and then in US, China and Europe, any attempt to withdraw stimulus and “normalize” policy is inevitably met by a decline of asset prices and a deterioration of credit and economic conditions. A feedback-loop where policy encourages ever growing level of debt which, in turn, increase the fragility of the financial system therefore begetting more government intervention. In other words, the large stock of debt and the associated risk of default hold policy hostage and require increasing rounds of intervention to manage the increased levels of downside risk and prevent a global credit crisis.

Market participants have come to understand and take advantage of such feedback-loop; as the economic conditions deteriorate, bonds are a “buy” due to the expectation of lower rates in the future. For the same reasons, albeit counter intuitively, worsening credit and economic conditions also make equities more attractive as participants anticipate a new wave of monetary and fiscal stimulus. Since last fall, it has in fact become clear that equities price stability has become the third, unspoken, mandate of the US Fed and that they will do “whatever it takes” to support stock prices.

Expansive policies have been critical to the rise of equity prices as they have powered stock buybacks, enabled the roll-over of dubious corporate debt and, more in general, supported valuations. Even if the effectiveness of such conventional policy measures was to dwindle, there is plenty of evidence that no policy tool is off the table and that today‘s’ “unconventional” will become tomorrow’s “norm”. In other words, if you don’t think the US Fed could buy the S&P index, just wait.

For the time being financial markets can continue to relax as the global level of debt can’t bear a meaningful decline of asset prices. Government intervention is therefore bound to continue and to become more extreme as current tools may start to become less effective. There is however also little doubt that sooner or later the inevitable “banquet of consequences” will come into play.