What would a bond market crash mean for stocks?
Posted on 01 April 2010 with 1 comment from readers
Some investors reading about the Bond King Bill Gross’s aversion to long-term treasuries are jumping to the conclusion that this should be seen as bullish for equities. Ergo money that was going into bonds will be funneled into stocks, and prices will soar.
Yet this is not really how the process would work in practice. If bond markets suddenly tanked and interest rates went up then stocks would be competing with the higher returns then available from bonds.
Equity crash
Far from pushing up share prices the impact of a bond market crash would be to also crash equities, for that is the only way that dividends paid on stocks could climb up to meet the higher yields available on bonds.
This is more clearly understandable when the impact of a bond market crash on real estate is examined. Higher interest rates would be very bad for real estate prices because higher mortgage costs raise the cost of owning a house as most owners have a mortgage to pay.
Indeed, the paradox of a bond market crash is that the asset it will make more attractive to purchase is bonds! You do not want to own bonds before the crash. But afterwards? You will be offered high yields with little downside capital risk. Why hold equities or real estate when you can get great returns on bonds?
But is there any historical precedent for a smooth rotation out of bonds and into equities? You really have to go back to the US bond market post World War II and the start of the equities boom in the 1950s for an example.
1950s precedent
True the US then carried a huge debt burden and also financed the global recovery. But US manufacturing was much stronger then and the competition far weaker. Besides equities were coming from a much lower base.
After the rally of the past year from the devil’s bottom of 666 on the S&P 500 the stock market is on a prospective price-to-earnings ratio of 22 and priced for a strong economic recovery, not the shock of a bond market crash. What would be left of the bank balance sheets that are pumped full of government paper financed with zero cost loans in return for their profitable yield?
It would not be a pretty picture for asset prices with deflation all round. Cash and precious metals would be the only winners with their purchasing power consequently higher.
1 Comment posted by readers:
High interest rates will send government deficits through the roof. That will cause all kinds of problems from higher taxes and lower growth. A downward spiral could start. And since the debt market dwarfs the size of the equity market, a bond crash could easily bring down the whole financial system.
I doubt if more than a handful of people have any idea of what might happen in the $500,000,000,000,000 dollar derivatives market. The things are so complex, interconnected, and have grown so fast, that anything is now possible if interest rates suddenly rise. Look at how the idea of CDOs worked out. Not too well.
If you want to see what these esoteric financial instruments can do, and how dangerous they really are, to all but the insiders who get rich selling them, read the latest Matt Taibbi article, ‘Looting Main Street’ on rollingstone.com on what happened to Jefferson County, Alabama after JPM sold them interest rate swaps. It will shock you. And they are far from unique. That sewer plant might end up costing more than the International Space Station. At least some folks went to jail.
The series of articles by Paul B. Farrell on the marketwatch.com site, discussed the various debt bombs out there, which he is convinced are about to explode and cause another Great Depression. If you read Mr. Farrell’s bio, you will see that he is no flake. And the chief Market Watch economist, Irwin Kellner, seems to share a similar view. He is telling Obama that the time to do another stimulus is running out. These men are rich enough to retire. What motive would they have to lie, and look like fools in a couple of years, if everything is just fine? They can keep their jobs without predicting financial catastrophe.
You’ll want some gold and silver coins if they prove correct.