New paradigm of bond and stock prices

  |  by Alexander Chepakovich

In modern economy bond and stock prices, contrary to conventional economic theory, move in a lockstep. The recent rise of both is just a sign of excess liquidity. A fall in bond prices will signal the end of the equity bull market.

Many investors are puzzled by the recent strong performance by stocks and bonds alike. In conventional theory when stocks rise that signals increase in economic activity, which is associated with greater demand for money, thus causing interest rates to rise that results in falling prices of bonds. Why this relationship does not hold this time and what it means for investors?

In my opinion, the current situation is a result of excessive liquidity: there is so much excess money that it is put both into the stock and fixed income markets. Well, one could ask why inflation is not rising then – any textbook on economics will tell you that when there is excess money prices of goods and services go up. I venture to offer the following explanation: the modern economy is very efficient and can satisfy increased demand for almost anything at no extra unit cost. Except for items that are inherently in limited supply, such as land, for example.

As far as stocks and bonds are concerned, their issuance generally is a function of requirements by companies and governments in capital for equipment or investment projects. What I see, in America at least, is that GDP steadily becomes less capital intensive.  Take a look at the most valuable US companies – many of them have no capital assets to talk about. The corporate sector as a whole, probably, generates more cash than is needed for its further development and either hoards cash or distributes it to shareholders in the form of dividends and share buybacks. The US government, though a big spender, has not embarked yet on the massive infrastructure investment program it has announced to be planning.

The result of excess supply of money results in inflation, but inflation of a different kind – rising prices of stocks and bonds. How long will this continue? To answer this question one needs to make a supply-and-demand projection and determine the point at which the demand for money will exceed its supply. It is much easier said than done, of course. Luckily, there are indirect indicators of this balance. I, for one, will be closely watching bond yields: they should begin to rise – and bond prices to fall - when demand for money outstrips supply. When this happens stocks should fall too.

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