Maverick's World

Another drop in the Dow - this time they say it is driven by bond yields

CNBC has an article explaining why the stock market is tanking. The basic thesis is that bonds are becoming more attractive as bond yields are rising. The rising bond yield lures investors away from stocks which drop in value, which in turn draw investors back and drive up the prices and then investors chase bonds and so on.

This is a very good description of what happens in a PID loop (read earlier post on that matter). No PID loop works perfectly, there is always a frequency at which you see huge oscillations in the system due to the action of the loop. Since most traders and bankers don't study math or signal processing or physics (they graduate with degrees in American Studies instead) - they have no clue that such phenomenology exists so it is natural to see this kind of behavior in the market.

But this does not explain what caused the bond yields to rise. It turns out that for the past month, there has been a steady drum beat of articles saying that the new Fed Chair will increase interest rates. A lot of big banks have been talking about hiking interest rates (after all per Donald Trump the economy is doing so well). That talk apparently has sparked a bit of a panic in the markets. Even before the actual rate hike has been announced, the market is moving to cope with the inevitable pain that is to follow. Hence the rise in the bond yields.

So we have two questions that don't seem to have answers

1) Why is the interest rate likely to rise?

2) Why do investors find bonds (which have traditionally lower yields than the market) more attractive?

The answer to the first question (IMHO) is that the Fed's biggest debtor - the USG is cutting taxes per Donald Trump and the GOP's instructions. All bipartisan estimates indicate a trillion dollar short fall in the foreseeable future. With declining revenue and the GOP-of-Trump completely abandoning all notions of fiscal responsibility, it is clear that anyone lending money to the USG will charge higher interest so as to coerce the USG back on to the path of fiscal incentive. There is no guarantee but they at least have to try. There is a rumor doing rounds that Trump blew it with the major bankers in Davos, they all came away with the idea that Trump was unhinged but that is a rumor.

The answer to the second question, I feel follows from the first. As the traders in the market are far more informed of the details of what is likely to affect the rate of return on a stock investment, the general sense in the market appears to be that borrowing money to buy stocks on the market at a time when interest rates might rise is risky.  As the market is already so high up, any transaction is very expensive and the interest on large sums of money is substantial. If I am even slightly unsure that I can make a profit that exceeds the interest I owe, I am unlikely to enter into a stock purchase and I will try to reduce my exposure to stocks and buy something like bonds instead.

The idea is gaining ground that the bankers are going to jack up the interest rates. If that idea gains ground, then the see-saw effect of the bonds vs stocks seems like a trivial follow on.

posted by maverick @ 9:56 AM