Good economic news is on the horizon, and it’s shaking the markets. Wait what?

The first signs that the world is winning the battle against COVID-19 have sparked good news for the global economy as the number of people vaccinated increases and the death rate drops.

Once stores and factories reopen, once those trapped working from home are finally free to spend on dining and travel, sharing any savings they were unable to spend during the lockdown, this recirculating money is what will make the savings strong.

So it’s fair to ask why the stock markets fell last Thursday – the Dow Jones and the Toronto market were down again on Friday – if the economy recovers.

Like Jim Reid, research strategist at Deutsche Bank told the Financial Times last week this “turned out to be nothing less than a rout in global markets, as the sale of sovereign bonds accelerated as investors eagerly awaited the prospect of a stronger economy. over the next few months “.

A global rout of the markets, a liquidation of bonds, all due to the prospect of a strengthening of the economy? The explanation involves the uncertainty of where interest rates go from here if a post-COVID-19 economy is brewing.

The market not the economy

But the first step in understanding the paradox is to remember that “the stock market is not the economyas US Treasury Secretary Janet Yellen once said.

In the long run, there is no doubt that a strong and growing economy adds to the value of the businesses that operate there. A study of 17 advanced economies by researchers from the University of Bonn have shown that in the long run, total stock values ​​increase with gross domestic product.

US Treasury Secretary Janet Yellen leaves the White House. The stock market is not the economy, she once said. (Tom Brenner / Reuters)

But as we clearly saw last year when U.S. stock markets hit record highs even as GDP shrank more than it had in 70 years, this relationship is not perfectly in sync. .

In Canada and the United States, central banks have expressed confidence that the economy will experience strong growth this year and next. Not only that, but to help get people back to work, Bank of Canada Governor Tiff Macklem and Fed Chairman Jerome Powell have promised to keep interest rates low until there are clear signs that employment and economic activity have picked up.

Everyone therefore seems to agree that the economy will strengthen. But as central banks try to keep rates low, there are growing signs that private investors in the bond market expect rates to rise, making existing bonds less attractive.

Rising interest rate?

Bonds aren’t usually the topic of table discussions in Canadian households, but the interest rates set in bond markets affect Canadians in many ways, including the rate you pay on your mortgage. According to Rate Spy mortgage brokers there are early signs that mortgage prices could follow rising bond yields.

The key point to understanding the role of bonds in the rising economy is one of the things people often find most confusing about them: Existing bonds lose value as interest rates rise. (For more explanation of how this works and why bonds are important, this previous column serves as an introduction.)

Like Reuters reported Friday, “From the United States to Germany and Australia, government borrowing costs on Friday were expected to end in February with their biggest monthly increases in years, expectations of a post inflation trigger. -pandemic having earned their living “.

Bank of Canada Governor Tiff Macklem has said he expects any rise in inflation to be temporary, but bond traders appear to disagree. (Blair Gable / Reuters)

Economists are divided on whether the low interest rates set by central banks and the massive injections of liquidity into the economy announced by governments will lead to inflation. Macklem offered a fairly firm ‘no’, but it appears that last week the mass of global bond traders appeared to disagree with the Governor of the Bank of Canada and voted with their money. On Friday, some suggested that the change in bonds was in fact due to technical factors.

Confusingly, the bond market’s anticipation of inflation – if that is what it is – is a vote of confidence in the future, as traders believe consumers and businesses will want to buy more. goods and services, thereby increasing their prices.

Speculation vs fundamentals

As for why stocks fell in response, there are a number of possible reasons, especially in a market where some fear. a growing stock market bubble. The first is that higher bond prices increase the cost of borrowing for companies that raise funds in the bond market. Another is that companies have to compete with bonds in the money they pay out in dividends. Both reduced profits.

But perhaps most interesting is the idea that the 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) based on actual performance.

“Markets are increasingly dominated by price action. The more prices fall, the more they sell,” James Athey, investment manager at Aberdeen Standard Investments told the Wall Street Journal Last week. “The problem is, not all investors are fundamental investors.”

In a market where traders have made bets on bitcoin with no profit or companies that have so far failed to cover their costs, a shift to a ‘fundamental’ investment where valuations are based on what ‘a business is likely to win in an economic boom could lead to greater long-term market stability. But there can be a bad patch at the start.

Follow Don Pittis on Twitter @don_pittis

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