Greater America

The bond market is telling the stock market to expect higher yields. This morning, we learned that American investors have anchored their inflation expectations between 3% and 4%.

What was it the Greek philosopher Heraclitus said? ‘You can never step in the same river twice.’ The world never stops changing, although lately the rate of change seems to be a lot faster. Still, some lines, once you’ve crossed some lines you can never go back.

Or rivers!

Did you know that it was on this day in 49 BC that Julius Caesar supposedly crossed the Rubicon and brought the 13th Legion on to Italian territory? This was against Roman law. Generals were supposed to enter Italy and Rome without the backing of their legions.

But Caesar had a bone to pick with Pompey and the Senate. He broke the law, crossed the river, and started a Civil War. The Republic (which had ended in everything but name already) was history and the Empire began. Hail Caesar!

We’ve talked a lot about whether the 5% ‘line in the sand’ for the 10-year Treasury is a financial river which cannot be crossed (sorry to mix the metaphors, but you know what I mean). Well, it CAN be crossed, if market forces are in charge. But that’s the issue (one Rising bond yields are a red flag warning for stock prices. Can the Feds disarm this price signal from markets, or prevent it from having negative consequences?

In point of fact, 5% is nothing special when it comes to average long-term bond yields. Since the 30-year Treasury was introduced in 1977, the average yield on it has been around 5.5%. It’s only in the last quarter century that investors have come to expect/demand/become dependent on abnormally low interest rates. Even on 10-year rates (the chart above), 5% and beyond is the norm.

True, as we’ve shown in the past (over seven centuries) the ‘risk free’ rate in markets has been in decline. But in the late 20th century and early 21st, governments have so massively abused their money printing and borrowing privileges that the Primary Trend for interest rates is now up.

This is why UK gilt yields went over 5% this week. US 20-year yields have already followed them, with 30-year yields knocking on the door. But what does this have to do with stocks? Take a look at the chart below.

. Bonds are pricing in ten years of this inflation with higher yields and lower prices. Stocks are not.

The chart above is from my colleague Alsadair Macleod at Macleod Finance. You may remember Alasdair from our Private Briefing last summer. This chart shows the ‘valuation gap’ between 30-year US Treasuries and the S&P 500. They’ve trended and traded together since the mid 1980s. And now?

And now investors are valuing stocks as if interest rates can’t go above 5%. This is a bet that inflation (actual) and inflation expectations (psychological) are wrong, or at least headed lower. Markets cut the probability of rate hikes this year from two to one on the back of today’s jobs data.

But judging by what people are doing with their money (buying stocks when nearly every single valuation metric is off the charts) there is still a strong belief/hope/prayer that something, anything, is going to bring both inflation and bond yields down so stocks can remain on their Permanently High Plateau.

Even if there were $50 trillion of offshore oil on the national balance sheet, and even if Trump strong-armed Denmark into selling us Greenland and all its natural resources, I’m not convinced America’s going to be able to un-cross the debt Rubicon of the last ten years. I’ll get to what may be Trump’s ‘Grand Strategy’ with respect to Canada, Mexico, and the Arctic in just a second. But for right now, and for investors, listen up. Bonds are warning you.

The bond market is telling the stock market to expect higher yields. This morning, we learned that American investors have anchored their inflation expectations between 3% and 4%...