The first signs that the world is winning the battle with COVID-19 has sparked great news for the global economy as the number vaccinated grows and the death rate falls.
Once shops and factories reopen, once people trapped working from home are finally set free to spend on restaurant meals and travel, sharing the savings they couldn't spend during lockdown, that recirculation of money is the very thing that will make economies strong.
So it is fair to ask why stock markets tumbled on Thursday — the Dow and the Toronto market were down again Friday — if the economy is recovering.
As Jim Reid, research strategist at Deutsche Bank told the Financial Times last week it "proved to be nothing short of a rout in global markets, with the sell-off in sovereign bonds accelerating as investors looked forward to the prospect of a strengthening economy over the coming months."
A global rout in markets, a sell-off in bonds, all due to the prospect of a strengthening economy? The explanation involves the uncertainty of where interest rates go from here if a post-COVID-19 economy gets cooking.
The market not the economy
But the first step in understanding the paradox is remembering that "The stock market isn't the economy," as now-U.S. Treasury Secretary Janet Yellen once said.
Over the long haul, there is no question that a strong and growing economy adds to the value of the companies that operate within it. A study of 17 advanced economies by researchers at the University of Bonn showed that over the long term, total stock market values climb with gross domestic product.
But as we clearly saw last year when the U.S. stock markets hit record highs even as GDP shrank more than it had in 70 years, that relationship is not perfectly in sync.
In both Canada and the U.S., central banks have expressed confidence that the economy will grow strongly this year and next. Not only that, but to help put people back to work, both Bank of Canada governor Tiff Macklem and Fed Chair Jerome Powell have promised to keep interest rates low until there are clear signs the employment and business activity have recovered.
So everyone seems to agree the economy will grow stronger. But while central banks try to hold rates down, there are increasing signs that the private investors in the bond market are anticipating rates will rise, making existing bonds worth less.
Interest rates rising?
Bonds are not generally the subject of supper table conversation in Canadian households, but the interest rates set in bond markets affect Canadians in many ways, including the rate you pay for your mortgage. According to mortgages brokers Rate Spy there are early signs that mortgage prices may be following bond yields up.
The key point to understand the role of bonds in the rising economy is one of the things people often find most confusing about them: existing bonds fall in value as interest rates rise. (For more explanation of how that works and why bonds matter, this previous column serves as a primer.)
As Reuters reported on Friday, "from the United States to Germany and Australia, government borrowing costs on Friday were set to end February with their biggest monthly rises in years as expectations for a post-pandemic ignition of inflation gained a life of their own."
Economists are divided over whether low interest rates set by central banks and large injections of cash into the economy announced by governments will lead to inflation. Macklem has offered a pretty firm "no" but it appears that last week, the mass of global bond traders appeared to disagree with the Bank of Canada governor and voted with their money. On Friday some suggested the shift in bonds was actually due to technical factors.
Confusingly, the bond market's anticipation of inflation — if that's what it is — is a vote of confidence in the future, because traders think consumers and businesses will want to buy more goods and services, driving up their prices.
Speculation vs. fundamentals
As to why stocks fell in response, there are a number of possible reasons, especially in a market where some fear a growing stock bubble. One is that higher bond prices increase the cost of borrowing for companies that raise money in the bond market. Another is that companies must compete with bonds in the money they pay out in dividends. Both cut into profits.
But perhaps most interesting is the idea that stock markets are going through a transition from speculative casino-style investing, where people buy more because they see prices go up (and vice versa) to one based on actual return.
"Markets are increasingly dominated by price action. The more price falls, the more they sell," James Athey, an investment manager with Aberdeen Standard Investments told the Wall Street Journal last week. "The problem is that not every investor is a fundamental investor."
In a market where traders have been making bets on bitcoin with no earnings at all or companies that have so far failed to cover their costs, a switch to "fundamental" investing where valuations are based on what a company is likely to earn in a surging economy could lead to greater market stability in the longer term. But there may be a rough patch first.
Follow Don Pittis on Twitter @don_pittis
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