Equities VS Bonds, why the current divergence?Introduction: should we finally go back to buying bonds? While the equity market has rebounded vertically since mid-April and the start of a period of trade diplomacy between the USA and its main trading partners, bond prices have remained at a low level.
Although both realized and implied volatility have fallen sharply in recent weeks (see our bearish analysis of the VIX at the end of April), how can we explain such a divergence between the recovery in US stock prices and a bond price still at the bottom?
For bonds, is this an opportunity to position at an attractive price?
1) First of all, take a look at the two charts below, which show the underlying trend and the recent trend of the S&P 500 (for the equities market) and the 20-year US interest rate contract (to represent the bond market)
Chart showing weekly Japanese candlesticks on the S&P 500 future contract
Graph showing monthly Japanese candlesticks on the US 20-year bond contract
2) The reasons for the outperformance of equities versus bonds are numerous and fundamental
The underperformance of bonds versus equities is based on a combination of fundamental factors:
- Firstly, corporate profit forecasts remain optimistic for the next 12 months, creating a favorable arbitrage for the equity market (see our previous analysis of the S&P 500 index).
- The Federal Reserve's (FED) intransigence in the face of the risk of a rebound in inflation against the backdrop of the trade war. The market does not expect a resumption of the US federal funds rate cut before the monetary policy decision on Wednesday September 17. The inverted correlation between interest rates and bond prices is therefore a factor putting pressure on prices.
- Beyond monetary policy, the United States' fiscal trajectory is also a topic of debate. The Republican bill to massively lower taxes could further deepen the federal deficit and add to an already colossal public debt, keeping long-term interest rates high. All the more so since, according to the Peterson Foundation, nearly $9.3 trillion in debt will mature over the next 12 months, adding to the estimated $2 trillion in deficit financing needs.
- The new all-time high in global liquidity is creating a favorable arbitrage for risky assets in the stock market, due to the positive long-term correlation between the S&P 500 index and global liquidity
3) Even so, current bond prices are in a technical zone of long-term interest, and forward-looking fundamentals could allow bonds to rebound in the coming months
The latest macroeconomic indicators confirm a loss of momentum in the US economy. In April, producer prices suffered their sharpest contraction in five years, suggesting that companies are absorbing some of the higher costs associated with trade tensions. At the same time, retail sales stalled, as consumers cut back on purchases in the face of persistent inflation on imported goods. If confirmed, these signs of a slowdown could lead to a “flight to quality” phenomenon, i.e. arbitrage in favor of the bond market over the coming months.
The chart below is a reminder that the US bond market is currently at a major technical support level.
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