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Crowding Out Stocks

The bond market didn’t care much more for the 7-year Treasury today than they did the 5-year yesterday. While there wasn’t as much of a tail, we have to remember that is partly because yields were up 25bps over the two days prior to the auction. Although the market rallied off the worst levels of the day, TYM0 was still -17.5/32nds on the day and the 10y yield hit 3.89%. It is a little early to be sure, but it certainly appears as if the 4% psychological hurdle will be tested. Some people, in fact, will begin to see an inverted-head-and-shoulders pattern in the charts; suffice to say that the formal projection of such a pattern would project to well over 5% in nominal yields.

I’m not a big fan of technical analysis, although it was working for a technical analysis firm that I got my career started. But some patterns are so very obvious on the charts that you just know other investors or traders will notice them and pay attention to them. The definition and interpretation of head-and-shoulders patterns is very subject to the eye of the beholder, as is most of this stuff, but when you look at the chart below (Source: Bloomberg) it’s hard not to notice. When it’s “hard not to notice,” I tend to take notice.

Chart: If the techies have their way, this could get ugly.

Today’s Initial Claims data didn’t hurt the bear case, although 442k isn’t exactly a sign of overwhelming strength. It was still stronger than the consensus expected. When trends begin, sometimes reinforcement from otherwise-innocuous data and news carries greater weight since investors tend to exaggerate the importance of information that supports their views (a.k.a. confirmation bias).

The general increase in rates helped drag stocks down after a hot start to the day. The S&P ended -0.2%. Swap spreads bounced very mildly from yesterday’s levels; “close to unchanged” is probably a better description given the extent of the recent decline.


The fact that rates are suddenly starting to act as if they aren’t excited with the prospect of huge deficits as far as the eye can see…and the fact that we don’t really have any alternative at this point to the plan of running huge deficits as far as the eye can see…is one reason to fear and despise the corner that we have painted ourselves into. Higher bond rates are painful if, for example, you are a bond investor, but also of course for borrowers of all stripes. But even if you’re primarily an equity investor, you should also worry about these deficits.

One of the reasons that large structural deficits (rather than small, cyclical deficits) are so damaging to an economy is that the pool of savings is not unlimited. When the government borrows money for unproductive enterprises (in the sense that they don’t produce, not that they don’t “work”), it is competing for that money against private borrowers. When deficits are small, relative to GDP, this is not a large problem. But as deficits grow more substantial, this “crowding out” raises the cost of capital for other borrowers. One can easily imagine how that may cause private borrowing rates to be higher than they otherwise would be, but what is interesting is that we can see this effect quite clearly in the stock market as well – as the deficit increases, the cost of capital in the equity market rises (that is, prices decline). The chart below (Source: Bloomberg, US Treasury) shows how the 3-year annualized return to stocks is strikingly correlated to the 3-year change in the budget surplus/deficit as a percentage of nominal GDP.

If you're an equity investor, you too are affected by 'crowding out'

Now, we ought to be somewhat careful about attributing causality here. When the economy tanks, the deficit clearly worsens (Keynesian automatic stabilizers), and we might expect stocks to do poorly as well. Moreover, when stocks decline then capital gains tax receipts decline and (therefore) the deficit tends to increase. But this relationship is too good to shrug off entirely to those alternative explanations. I believe you can make a pretty reasonable case that running very large deficits (a) tightens credit spreads to Treasuries as the latter cheapen, (b) tightens swap spreads to Treasuries for the same reason – see yesterday’s comment, and (c) by competing for a larger share of the available savings, raises the cost of capital to firms across the entire capital structure…including equity capital.


On Friday, the final revisions of Q4 GDP figures should not have any market-moving implications. Nor should the revision to the monthly Michigan Confidence figure. So technical pressures, rather than economic news, should rule the day I think.

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