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Marketplace Scratch Pad

On stocks and bonds

Scott Jagow Nov 23, 2009

Let’s take note of what’s happening in the stock and bond markets as the year comes to a close. This may also help answer another reader question. Nic asks: Is the stock market artificially inflated right now? By what? What does that mean for the future? How will that affect other parts of the system?

Some economists, like Nouriel Roubini, have warned that stocks and commodities are asset bubbles waiting to pop when interest rates rise. Right now, investors are taking the Fed’s cheap money and pouring it into stocks, oil and gold. From Marketwatch:

Such non-fundamentally driven asset price inflation can continue until sometime early next year, Roubini said, but the removal of easy money by global central banks might bring about a shock to those assets that have rallied the most on pure speculation.

For now, though, we have an unusual confluence of events. Stock and bond prices are both rising. Usually they move in opposite directions.

It’s common toward the end of the year for investors to “lock in” stock market gains and sell. They don’t want their portfolios to blow up in December after a 58% gain in the Dow since March, so they jump into bonds. This year, the jump into the safety net is happening earlier and with more intensity, but despite that, the stock markets continue to rise. From the Wall Street Journal:

The most concrete sign of these year-end trends is in the government-bond market. Investors have been snapping up short-term Treasury bills, particularly those that come due in January 2010. The buying has been so intense that on Thursday and Friday it drove the yields on some of those bills into negative territory–in other words, buyers were effectively paying the government to keep their cash safe until the start of the year.

Treasuries paying zero or negative interest while stocks continue to climb? It hasn’t happened since the late 1930’s. In that case, it was a sign that stocks were about to crash:

As 1939 began, stocks began a three-year, 34 percent decline after the Fed increased borrowing costs prematurely to stymie inflation that never materialized.

Ah. Interest rates went up. Federal Reserve chairman Ben Bernanke knows that story like the back of his hand:

While almost no one expects Bernanke, a self-described “Great Depression” buff, to raise rates before mid-2010, bond investors say with unemployment above 10 percent and housing taking another downturn, they have no qualms about lending the government money for nothing to ensure their capital is preserved. Stock investors, meanwhile, say the worst is over and that low borrowing costs coupled with the $12 trillion of fiscal and monetary stimulus will bolster earnings.

The question is how long will investors have an appetite for government bonds and stocks? And as Roubini points out, what happens when interest rates do rise? That could be the story of 2010. More from Bloomberg:

“A lot of these markets have been driven by excess liquidity and are not necessarily supported by economic fundamentals,” said Thomas Girard, a managing director at New York Life Investment Management who helps oversee $115 billion in fixed-income assets. “Clearly there is a class of investors that are nervous,” said Girard…

If stocks do collapse again, it would have a broad impact on the recovery and the job market, but it’s hard to predict how bad the fallout might be. Bloomberg puts it this way:

Fed officials are stepping up scrutiny of the biggest U.S. banks to ensure the lenders can withstand a reversal of soaring global-asset prices, people with knowledge of the matter said last week. Supervisors are examining whether banks such as JPMorgan, Morgan Stanley and Goldman have enough capital for the risks they take, how much they know about the strength of their counterparties.

“At some point reality is going to bite us in the backside,” said Michael Cheah, who manages $2 billion in bonds at SunAmerica Asset Management in Jersey City, New Jersey. “We are living in the best of times and the worst of times. Unfortunately the best of times cannot continue celebrating like this when the economic fundamentals are worsening rapidly.”

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