One of the best performing investments of recent months has been an obscure Austrian bond that will not pay off its investors for nearly a century.
The Republic of Austria bond, maturing in 2117, has jumped nearly 36 per cent in price since early October, easily outpacing global stock markets.
This is not because of a sudden outburst of enthusiasm for central European debt. Rather it is because bond prices move in the opposite direction to bond yields, and yields around the world have tumbled since late last year. The biggest beneficiaries have been bondholders, especially those owning bonds that mature far in the future and are therefore most sensitive to changes in yields.
Slumping yields suggest bond investors are bracing for much slower growth ahead. Rushing into bonds makes sense if you expect economic expansions to sputter and yields to fall even lower.
But there is a complication to this simple story. Despite all the angst on display in the bond market, stocks appear unruffled. After a big fall late last year, they have largely recovered and are hovering near record highs. If anything, they are signalling optimism about what lies ahead.
It is rare to see financial markets so directly contradicting each other. Even the most experienced observers aren’t sure what to make of it.
“It’s hard to explain the divergence between the two,” says Mark Chandler, managing director at RBC Capital Markets.
He says the bond market appears focused on the potential impact of international tariff wars, while the stock market seems to be looking at the here and now. In Canada and the United States, it is hard to square a dire outlook with the current reality of high profit margins and low unemployment rates.
The differences between the stock and bond markets are likely to narrow over the coming month, Mr. Chandler says. Investors will be watching to see whether the United States goes ahead with its threat to impose tariffs on Mexican production, beginning June 10. They will also be monitoring the Group of 20 summit in Japan at the end of June to find out if the U.S. and China can narrow their disagreements on trade.
In the best case for stock investors, Washington’s hard line on Mexican imports will soften and U.S. President Donald Trump and Chinese President Xi Jinping will stop throwing verbal grenades at each other. If so, the stock market’s optimism could be justified.
And if that doesn’t happen? Get ready for turbulence.
Recent economic data have been a mixed bag. Low unemployment and robust earnings continue to provide good news for stocks in North America. On the other hand, the JPMorgan Global Composite purchasing managers’ index has sunk to its lowest level in nearly three years. The Citigroup global economic surprise index, which measures how actual economic readings are coming in compared with forecasts, shows a steady pattern of disappointment since late last year.
To John Higgins at Capital Economics, the recent rise in bond prices, especially among U.S. Treasury bonds, indicates bond investors expect a slowdown. Those investors are buying bonds, and pushing down yields, because they want to get ahead of the U.S. Federal Reserve, which lowers rates to buffer the economy against weakness.
The stock market is ignoring the gathering gloom, but it will eventually catch up, just as it did during similar episodes in 1999 and 2007, he says.
“It is common for the S&P 500 to continue to rise while Treasuries rally – as they have done recently – in response to expectations of looser Fed policy,” Mr. Higgins wrote in a note this week. “The S&P 500 typically falters when that expectation is vindicated by economic weakness, which is what we now project.”
The S&P 500 is likely to finish the year around 2,300, nearly 20 per cent below where it now sits, Mr. Higgins says. He isn’t forecasting a recession, though – “just a significant economic slowdown.”
Not everyone is so sure. Larry Summers, the former U.S. Treasury Secretary, is among those who see reason for alarm. He raised eyebrows on Wednesday when he urged the Fed to cut rates by half a percentage point this summer and cut even more, if necessary, in the fall.
He worries that if the central bank doesn’t act quickly to counteract economic weakness, it could find itself struggling to catch up to a deeper downturn. With interest rates already so low, the Fed has little room to reduce them further, and so it should flex its muscles now, when it can still hope to stave off a recession, rather than wait for serious weakness to emerge and find itself short of ammunition, Mr. Summers says.
The growing case for rate cuts may provide the most robust explanation for stock market optimism: If you believe lower interest rates are a tonic for share prices, the prospect of rate cuts ahead is welcome news.
The problem with that viewpoint is that it amounts to saying that a weaker economy will turn out to be good for stocks. This is not a bet that seems guaranteed to turn out well.