Stocks Thump Yields as Growth Looks on

by Ashraf Laidi
Jan 27, 2012 16:51 | 5 Comments

It is not a new development for US GDP growth to be largely driven by a build- up inventories (+1.9% contribution is highest since Q1 2010) in contrast to weak contribution from real final sales (+0.80% is lowest since Q1 2011). If this is a signal to future growth prospects, then how will the ultra low yields-driven stock go on?

This helps explain the weaker than expected 2.0% rise in personal consumption expenditure (PCE), following 1.7% and 0.7% in Q3 and Q2 respectively. The PCE chart (red graph) shows a potential dead-cat bounce, which may fail to regain the 3.6% high attained in Q4 2010. Finding the growth will be challenging, especially as stalled US budget negotiations risk forcing $1.2 trillion sequesters (automatic cuts in discretionary spending) starting this year.

And if GDP growth will in fact slow as is forecast by the Fed, then how will equities maintain their surge? The chart on the right highlights the latest record highs in equities relative to 10-yr bond yields. The argument in favour of further gains in stocks/yields ratio is healthy corporate balance sheets, bond traders expectations of persistently zero rates, subdued growth and benign inflation.

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Stocks Thump Yields as Growth Looks on - GDP Comps Vs SPX Yields Jan 27 (Chart 1)

Technically, the S&P500/10-yr yields ratio is nearing overbought levels as suggested by a peak in momentum. The pattern is similar to the peaks of early 2009 and late 2011.
Another possibility (less likely) for a decline in the socks/yields ratio is a run-up in bond yields. This could take the form of: i) fiscal concerns with the US; ii) rebounding sovereign yields on protracted threats from credit rating agencies; or iii) upside surprise in global economic prospects. With the higher yield argument unlikely to serve as the catalyst, the equity component risks a rude awakening when QE3 appears to lose the efficacy of its predecessors.

Fed's Zero Rate Extension

The Fed announced it would extend its interest rate policy (ZIRP) into another 2 years, the ECBs Long-Term Refinancing Operations will keep 1% money flowing for 3 years, and the BoEs their phase of quantitative easing (QE3) is imminent next month. The latest re-affirmation of zero cost money from the leading central banks has suddenly removed the threatening credit-ranging agencies from the headlines.

The latest euphoria lifted gold by $70 in two days, Italian 10 year bond yields fell below 6% for the first time since December 8, shedding 20% from their November highs, S&P500 hit a fresh 6-month high and the CRB index surged 2-month highs thanks to robust oil and metals.
The Fed's latest ZIRP extension relegated Eurozone concerns to the back-burner and turned markets' focus onto all that is positive; recovering US manufacturing sector, reduced supply of US housing; yield-reducing LTRO from the ECB; a looming deal on Greek debt and a potential 2-pronged Eurozone bailout fund (ESM w/ EFSF).

Downgrading the Outlook to Justify Zero Rates & Boost Sentiment

The Fed's continuous downgrading of economic projections in order to justify two more years of exceptionally low rates is aimed at signalling its readiness to do more. Despite Bernankes repeated statements that additional QE would not be rewarding from a cost-benefit analysis, the Fed Chairman recognizes all too well the positive (market) effect of additional QE. Therefore, hinting at QE3 to the markets without actually delivering it can only work for so long until we arrive at a phase similar to July-Oct 2011, when damaged markets licked their wounds after the Fed disappointed them by revealing Operation Twist (moving $400 bln of bond purchases from the short end to the longer end of the curve).

As long as the European Central Bank, the Federal Reserve and the Bank of England continue to attempt flattening their own yield curves via LTROs, Operation Twist and QE3 respectively, markets will have a solid reason to buy the dips at the next selling phase. And with Japans trade balance having officially shifted into deficit for the 1st time in 3 decades, the fundamental catalyst for a lower yen may finally be here in addition to improved risk appetite. Central bank liquidity is clearly assuming the role of building market confidence at a time of looming Eurozone recession, subdued global economic activity and sub-par inflation.

Markets run the risk of re-entering a fresh phase of central-bank driven market complacency, whereby rising equities go in tandem with falling bond yields at a time when none of the structural debt challenges have been resolved in the Eurozone, the US or the severely austere UK.

The chart below indicates that despite falling individual sovereign bond yields, the declines in spreads over those of German yields have been more modest. This is rather the result of a global bond yields story reflecting widespread easing (G10 and BRICs) and uncertain economic outlook.

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Stocks Thump Yields as Growth Looks on - Ezone Yields Spreads Jan 26 2012 (Chart 2)

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Comments (Showing latest 5 of 5) View All Comments
Moscow, Russia
Posts: 77
12 years ago
Jan 29, 2012 20:50
Ashraf, your post on S.A. went up uncorrected
Ashraf Laidi
London, UK
Posts: 0
12 years ago
Jan 29, 2012 17:09

Yes, it has been corrected. Thank you. Especially Optn Twist. Re your last question, i see that later in Q1


Yields would rise if i) growth expectations improve ii) fiscal deterioration escalates to threat of more downgrades. This all may be applicable, but may be offset by weaker growth & disinflation.


It's not a bad idea. Best to to GDP-weighted spreads vs EURUSD, kinda like baste of PIIGs spreads.

Kerkyra, Greece
Posts: 1
12 years ago
Jan 28, 2012 17:55
How sensible is it to construct a spread between price and yield and make conclusions?

LUGANO, Switzerland
Posts: 1
12 years ago
Jan 28, 2012 10:37
Hi there, why less likely? Quoting you: "Another possibility (less likely) for a decline in the socks/yields ratio is a run-up in bond yields"? I see Eur$ shorts all time high, 10y long all time high!
Posted Anonymously
12 years ago
Jan 27, 2012 21:56
It would appear to me the below should read as follows:

"As long as the European Central Bank, the Federal Reserve and the Bank of England continue to FLATTEN their own yield curves via LTROs, Operation Twist and QE3 respectively..."

Operation twist and LTRO have nothing to do with instigating inflation, one would presume...

Would be interested to know your view given that macro data out of the US is very much likely to deteriorate (word has it so) next month