Declining (Real) Rates Feel Great

As last week's Coaks' Notes highlighted much has been made about the precipitous decline in the US dollar while both equities and gold have approach all time highs.

An often cited explanation for the divergence has been the rapid increase in new coronavirus cases in the United States, but if that were the case wouldn't equities sell off as well?

There is actually a more powerful and long standing relationship which explains both and that is the influence that interest rates, as reflected in government bond yields, have on asset prices globally.

As we can see in today's price action, the US dollar is still very much in a risk on/risk off trading dynamic. A sour tone struck in both Asian and European trading sessions had the USD bid, while the S7P 500's open in the red this morning catalyzed rapid movement higher in the USD. Illustrating once again the asymmetric dynamic of the USD, it may grind lower but when it rise, it's with a jump.

As mentioned, government bond yields imply that credit markets are in a far less sanguine mood than their traditionally riskier cousins equities and commodities. While the latter two are signaling that an economic recovery is well underway US treasury yields have hit all time lows, as have a number of other sovereign credit markets like Canada's. Real bond yield, those measured against inflation, are actually negative and this may in a large part explain the continued rise in risky assets while also signalling that all is not well.

Historically there is a strong inverse relationship between real bond yields and gold prices as the cost of storing the shiny metal increases with (real) interest rates. Therefore, much of the decline in the DXY(USD) and gold can be explained by portfolio flows migrating out of negative yielding assets. To a certain extent it also goes a long way in explaining the multiple expansion which has been driving large cap tech stock prices higher as well. Since stocks like Apple, Amazon and Google have an out sized impact on market cap weighted indexes like the S&P 500 casual observers can't be blamed for thinking a recovery is well underway.

Looking back to US treasury yields their fall is likely telling us something more than that the Federal Reserve has been effective in their QE program.

Simplistically, US treasury yields are priced off of expectations of future inflation, growth as well as the availability of capital. It has been debated, and I would argue that it is likely, that there a structural savings glut has kept yields low for the last two decades, meaning the last variable is effectively irrelevant in this situation.

Instead, it appears that there is a divergence in perspectives which is also driving the divergence in price action between bonds and riskier assets. The bond market gives the impression that it is looking through short term headlines and sees an economy which is no where near recovered.

Initial jobless claims in the United States have declined from their peak but are still at rates that are double the peak of the global financial crisis. Consumer comfort has returned from it's lows but still remains a fraction of what it was before the shut down. Looking at same store retail sales they still haven't improved much from their bottom. When looking at higher frequency credit card data that includes online retail, spend has effectively sidelined for weeks at a level that is double digit percentage points below the pre-COVID-19 era.

The United States is not alone in this, in fact the data is similar worldwide. Since there is often a few months of lag between a shock and when the second order effects like bankruptcies start to show up, the decline in rates may feel great now, but we are not out of the woods yet.