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July 9, 2018

What bond yield curve tells us about stock market rally?

What bond yield curve tells us about stock market rally?

 

What’s happening with the bond yield curve today?

 

US structure of interest rates continues to flatten out, i.e. the difference between the interest rates on Treasuries of longer and shorter maturity has been decreasing steadily towards zero, what fuels rumors about the fragile growth of US economy we witness today.

At the end of last week, the difference between yields on 30 and 10-year US government bonds has dropped to 0.11 basis points – a record low which hasn’t been seen from during the height of 2007 mortgage crisis.

Recall that in times of favorable outlook in the economy (not current climate!), the yield curve have convex profile. In other words the interest rates for shorter-term debt are lower than for longer-one.

During the downturn or even at its onset, we start to observe flattening yield curve, because investors expect interest rates in the economy to slow down growth (expectations theory of interest rates) so short-term government bonds suffer from fall of the demand.

In other words, current shape of bond yield curve sends a wake-up call to the markets that conditions in the US economy may deteriorate noticeably in the near future. If we compare charts of both, we can see that the drop in bond yield spread was a harbinger of substantial correction of stock market averages like S&P 500:

 

 

bond yield curve and S&P500
30yr – 1oyr treasury spread and S&P500 joint dynamics. Period 1983-2010. Source: Brokerarena.com, Tradingview.com

 

 

spread on bond rates and S&P forecast
30yr – 1oyr treasury spread and S&P500 joint dynamics. Period 2010-2018. Source: Brokerarena.com

 

Since 2003, the following trend had emerged: when the difference in yields on 30-year and 10-year government bonds decreased, US stock markets grew. When the bond yield difference started to widen the stock preferred to fall, not counting 2009-2011 period.

In 2015-2016 years world markets were close to a collapse and the bond yield curve froze at about the same place and the difference in rates tended to grow slightly.

At the end of 2005, the spread between bond yields fell to the current levels and was there for two years it took a whole two years for economic crisis to mature in the US.

Upbeat US economic sentiments despite trade wars show there are no signals of imminent collapse on the US stock exchanges. Traders are certainly preparing for a comeback of a bear market, but for a full-scale correction, time will pass.

 

Copper-gold ratio – why we should track this?

 

Price of copper in gold – a leading indicator for some commodity traders shows little confidence about accelerating world economic growth in the near future.

To date, a ton of copper costs about 5 troy ounces of gold, which is half an ounce less than in early June. In other words price of copper in dollars has been depreciating against price of gold. During the market upswing, investors tend to become more risk-taking, reducing safe-heaven assets in their portfolio, while increasing share of cyclical assets which usually benefit from the rally of an economy.

Therefore, as the economy expands, the cost of copper in gold should increase, while reverse is true if we observe contraction of economic activity. Price will fall and bond yield curve for example will start to flatten out.

 

copper-gold ratio

The price of a ton of copper in troy ounces of gold. Source: Brokerarena.com

 

Recall that in late 2016 there was a sharp increase in copper in gold, which became a harbinger of the rally on American stock exchanges. Later, until January 2018, the indicator tempered growth. But already for half a year it is trades in the same tight range, and in the last week it’s even noticeably corrected.

Since June, the cost of copper has fallen by about 13%. This is partly due to the strengthening of the dollar. But at the same time, investors are extremely worried about the “trade wars” that could slow the growth of the world economy.

While this factor will restrain the optimism of investors it will be difficult for them to remain upbeat about stock market growth.

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