As trade tensions between the US and China rise, and doubts grow about the sustainability of the US expansion and the recovery in Europe, government bond yields in both regions are falling to recent lows. As investors seek the safe haven of sovereign fixed income, 10yr US Treasury bond yields have fallen to their lowest level since 2017 near 2.25%, and 10yr German bonds are currently yielding -0.16%.
Yet risk assets appear to not reflect any similar concern. Both the S&P 500 and Eurostoxx 50 indices are still ~12% higher year-to-date, and a mere 5% off their recent 2019 highs, which was put in before the recent rise in tensions. Bloomberg’s US Investment Grade Credit Index shows credit spreads have widened to 137bps from a recent narrow of 121bps, but that is far from the wides of 177bps seen in early January.
Why the divergence? What is behind the dynamic between bonds and stocks, where bonds are seeing a flight to quality bid yet stocks and credit are holding in fairly well on a relative basis?
I believe it is because risk markets are trading with the assumption for a potential “Trump Put” and a “Powell Put” if anything goes awry. Starting with the Trump Put, there appears to be an underlying belief that given how closely Trump looks at the stock market as a barometer of his success, and his perceived need to keep equities performing into the election, there is only so far he will allow stocks to fall due to things under his control. Meaning, if stocks were to fall due to the administration’s negotiations with China, he will fall back from his hard line approach and be more willing to make a deal.
But it’s truly with the Powell Put that some of the reason for the divergence itself comes to light in my mind. As trade fears rise, bonds see flight to quality, markets price in more Fed easing (and more quickly), the curve steepens, and US Treasury yields fall. Equities also fall, but perhaps not as much as one would think, because the expectation is that the Fed will come to the rescue of both the market and the economy. And, I would argue, the markets may believe this Fed’s rescue will be more aggressive than in the past, given how hard and fast Powell and the Fed shifted in Q1 this year, to similar circumstances when equity markets were declining.
So while on the surface it may appear these markets are disconnected, underneath they may not be: both may be pricing in policymaker support. The hazard here is that those assumptions may not be correct. Trump may not blink in the face of equity declines, and Powell may not ride to the rescue as quickly as before. So if those “puts” are not as close as investors think, there may be more downside to risk assets in the coming months, and more downside to sovereign bond yields as well.