Does the 1938 Analogy Indicate Bonds Are Topping?

I have posted a series of analogies in stocks to 1937-8 and more recently to 2008. These analogies are interesting although not predictive unless the underlying conditions are creating a similar investor psychology. The 1937 analogy seems particularly apt because a change in fiscal policy - a withdrawal of stimulus - seems to have caused a double-dip. (It certainly caused a roller-coaster of endless academic debate.) The greatest Keynesian Cheerleader of them all, Paul Krugman, is now analogizing our policy environment to 1938. 

We still seem inside those analogies in stocks. The 1937 picture would have predicted a drop off the August high (we got it) followed by a rebound that stalls below the August high (we are in the rebound, do not know where it will go). The 2008 analogy says after the August drop we come back to retest the August highs, then fall off a cliff. Both have a few weeks to go before they really get tested.

I am now seeing a similar analogy game applied to bonds, specifically Treasuries. PragCap compares our current rates to those in the 1930s, and speculates that we are coming soon to the end of rate drops:

 

The question is why will the Fed raise rates, especially after the recent public comments about QE2?  EWI continues to argue (convincingly) that the Fed responds to changes in market rates, rather than drives them. 

 

PragCap goes on to answer the question they raised, and the answer is consistent with the EWI perspective: rates will flatline when the recovery commences, since demand for borrowing will cause market rates to turn back up. The analysis is also why low rates are not inflationary, since they have not led to increased lending (or borrowing); only a recovery will do that. 

Yet how close are we too a recovery and thereby a top in bonds (and a bottom in rates)? You can read my countdown to the double dip in prior posts, in which I conclude that we are unlikely to dip until 2011. Even now the signals are still ambiguous. 

Instead of an imminent top, bonds have more to rise. R&B Capital put out a report on a massive decline in yields that got a lot of play. Barry Ritzholtz picks up this theme, and provides this chart showing that 20-yr government bonds are high compared with benchmark interbank rates in both the US and UK:  

 

The implication is that the mid- to long- end of the yield curve has room to keep dropping. 

Yet we have had a really strong rise in bonds over the past few months, the type of race to a category that ends badly, or least is likely to correct rather than continue. When you compare stocks to bonds over the past decade, bonds can be argued to be approaching a blow-of top of the sort stocks hit in 2000:

  

That correction may have started. 
 

Comments

[Mamma Boom Boom]

>Everyone should feel free to take a long weekend. Most of next week is going to be sloppy, you won't miss a thing.

Posted by: Mamma Boom Boom | Friday, September 03, 2010 at 12:14 PM<

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Da Da Da

[Michael]

NET OUTFLOWS from equity mutual funds are $42 Billion since April 2009, while net inflows of $450 Billion have found their way into Bond Funds.

If rates head back up due to more demand for credit given an expanding Economy, you will see every single tactical asset allocator bail out of bonds and shift into equities.

As a result, the stock market will SURGE and there will be no "P3" for all of those perma-bear bloggers like Daneric, Kenny, Molecool, and that David character at "Trading to Win (Lose)"

[ROLF]

No clue. Interest rate rise will kill bonds and stocks.

[Michael]

Rolf,

You are obviously a very poor student of history. The period from the Fall of 1987-1989 says that you have no idea what you are talking about.

[ROLF]

I've learned to disregard one-tracks, bear or bull, so there you go.

[Michael]

What you have learned is to conveniently ignore market history . . . and as a result, have zero credibility.

[ROLF]

Oh, an historian, please tell me, what happens next!

[JT]

Interestingly enough, for all of Prechter's DEFLATIONARY talk and that of P3... the Continuous Commodity Index ($CCI) just made NEW HIGHS for the YEAR!

Cotton making new highs.
Gold and silver surging higher.
Lumber limit-up today.
Grains skyrocketing.

And for the guy named "Rolfie" above ... higher rates would be BULLISH for stocks given that it means that the economy is recovering and top-line growth would be kicking in for Corporate America. Tactical AA guys would definetly lighten-up on Bonds and reallocate to equities. That is a FACT.

[ROLF]

I can't wait to see your head handed to you! On a discounted cash flow model, see what higher rates do to stock prices.

[Michael]

Like I said before, you have no idea what you are talking about... the fact that you conveniently IGNORE the Post 1987 "Crash" period is quite telling . . . as you are obviously unable to explain a rising equity market given the rising rates that occurred during that time.

Thanks for stopping by.
:)

[Les]

The Fed started printing money after the 87 crash. Both bonds and stocks rallied after the market bottomed in December. It's quite common throughout recent history after major declines for the Fed to rev up its printing, often in conjunction with partners in Europe (1995 and 2009) and Japan (1995 and 2003).

1991
1995
2003
2009

[Les]

Bonds and stocks can also fall together as it did from Dec 2008 to March 2009. It would obviously force the hand of the Fed to start up a bigger QE.

[Markus]

It is possible both equities and bonds will fall like it did in wave 3 of the 2007 crash, or if US credit gets a downgrade, or if the IMF announces the US dollar will be replaced as the world currency, or...
It all depends on confidence in the US economy.
As always Yelnik has produced a great piece on bonds - :)

[Dsquare]

Yelnick, you made an interesting observation in your last post which concerns Neely's count. Neely's count is suspect since August's decline doesn't show a convincing impulse down (nor a terminal impulse). I think Neely would say that because the 5th is truncated one of the other waves is extended, but that is a bit beside the point in that usually truncations of wave 5 occur when 3 is clearly extended (at least 1.618x of 1) and wave 4 retraces a considerable amount of wave 3 (that didn't happen). This current wave up should be an impulsive wave c if an ending flat is being made. I would expect that it would rise faster than the b wave of the second flat (double flat is Neely's count for the down move) so the longer it hesitates at 1100 the more likely Neely's count is wrong. An alternate count is the flat-x-triangle (x ending early June and not later in June as in Neely's count). Currently in d of e (e a neutral or expanding triangle). So it would still be possible to see 950+/- if e is an expanding triangle. The only thing (and DG can comment) that would make this count suspect is the length of time taken for phase 1 and phase 2 of the complex wave (phase 2 as a triangle might be taking too long). Not sure if Neely has ever commented on how much difference in time is allowed between the two phases of a complex correction. Do you know DG?

[yelnick]

Markus. thanks. I would caution all of us not to fall into the aphorisms of the industry, that low rates mean high stocks for example, or bonds & stocks go opposite. Bonds and stocks went up together from 82-00 as rates fell, then bonds have continued to perform while stocks have been down since '00 despite very low rates most of the time. Low rates since '00 indicate distress.

Hot money may have flowed from stocks to bonds, but never forget that the bond market is 10x bigger than stocks, and forex is 10x bigger than bonds, so merely showing 10x the move to bonds than stocks is just normal, not interesting. The rebirth of QE has spurred a bond rush, and the price increase in bonds 9drop in yields) may already bake in at least a $300B QE (or as one commentator out it, a 33% chance of a $1T QE). The ambiguous ISM data has momentarily cooled off the rush to QE, since if the economy does bumble along at a modest level the Fed may do less QE than expected - and bonds will fall!

[yelnick]

D2, Neely;s count requires the current up wave to go faster (steeper slope) than the recent down wave. Put simply, we have to get back to the Aug9 high faster than the fall to Aug27. We started off like that, and have begun to slow down.

[Dsquare]

Yelnick, I think that's true too, also because the truncated wave 5 is a failure (fails to take out 3's low). I think the way Neely put it was that if the 5th is a failure the wave should be entirely retraced in less time than it formed. But I also think the wave needs to be faster and further than the counter-trend wave of the second phase of the complex correction which was the b wave in his count.

[DG]

The only thing (and DG can comment) that would make this count suspect is the length of time taken for phase 1 and phase 2 of the complex wave (phase 2 as a triangle might be taking too long). Not sure if Neely has ever commented on how much difference in time is allowed between the two phases of a complex correction. Do you know DG?

Dsquare,

Here are two statements by Neely on this topic. I pulled them from past updates, so they aren't part of MEW or the Question of the Week section of the website.

"The second phase of a complex correction should consume at least 61% of the time of the first phase."

"Under NEoWave theory, the second phase of a complex correction will be related to the first in time by 61.8%, 100% or 161.8%."

I was also skeptical of the C-Failure count because I didn't see the last decline as an Impulse, either.

[Dsquare]

DG, Thanks, That does sound familiar.

[V07768198309]

Sorry to blow your bubble but Quantitative Easing is over since August 25, Quantitative Tightening is now on:

Operation TWIST Again: Quantitative Tightening

Giving Tempo to the TWIST.

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