Major economic themes of late suggest that both the bond market selloff and the stock market meltup appear to be overdone. The stock market is more than fully priced — what is ‘normal’ is for the S&P 500 to rise 20 percent from the lows to the end of the recession — and this bull-run (since the March lows) has been twice as pronounced. In fact, on average, we are up 40 percent from the lows when the economy has completed nine months of recovery — so you see what we mean when we say “fully priced.”Furthermore, the bond selloff is overdone too, notwithstanding the rush of supply (most of the Treasury auctions have actually gone pretty well, so this can’t be all about supply): Through a good part of the Treasury yield run-up, private sector rates were unaffected, but now we have the 30-year mortgage rate approaching 5.5 percent and mortgage refinancing activity has plunged about 60 percent in the last two months. Mortgage applications for new home purchases collapsed at a 20 percent annual rate in May too.
The futures market is priced for three Fed tightenings; however, historically, the Fed does not tighten and bond yields do not bottom until after the unemployment rate peaks. Question is whether the Fed will step up its coupon-buying program. We have already crammed into six months what it took 48 months to accomplish in the 2003-07 bear market — to see the 10-year yield soar 180 basis points from the low.
With inflation running at -0.7 percent YoY, we now have a ‘real yield’ of 4.5 percent — the last five times we got to this level, the nominal yield rallied 50 basis points in the next three months. As an aside, a 4.5 percent real government yield and 8.0 percent real corporate bond yield is serving up some major competition for equities right now.
David Rosenberg, Merrill’s former chief North American economist, has returned to his native Toronto and commenced duty with buy-side firm Gluskin Sheff & Associates.
