For many weeks, investors and market commentators have been puzzled by the apparent “disagreement” between the stock and the bond markets over the expected shape of the economic recovery. The sharp rebound of share prices seemed to indicate that equity investors foresee a swift, V-shaped comeback. The ultra-low, or even negative, yields and flat curves in the bond markets, in contrast, appear to imply a much lengthier recuperation. That said, a closer examination of the makeup of the share-price rebound reveals that the two viewpoints may not be as far apart as they appear.
Thanks to the FAANGs…
In her recent blog post on how The US market can thank its FAANGs, my colleague Diana Baechle noted that the positive performance of the US stock market in the first seven months of 2020 was largely due to the phenomenal run of the so-called FAANG stocks—Facebook, Amazon, Apple, Netflix and Google. Without the contributions of those five “tech giants”, the cumulative year-to-date return of the STOXX® USA 900 as of July 30 would have been -2.2% instead of the actual +1.5%.
Almost all of the biggest contributors to this performance were companies that could be expected to benefit from a COVID-like environment in which people are working remotely and doing most of their shopping online, i.e., Amazon, Microsoft, Apple, Nvidia, PayPal, Netflix, Facebook, Shopify, to name just a few. So, what may have looked like a swift “recovery”, could, in fact, just have been a consequence of the crisis and the subsequent lockdown measures put in place by the authorities. Some might even say that the US stock market is in positive territory not despite but because of the coronavirus crisis.
…and the central banks
Another, perhaps distorting, factor was the role of the world’s largest central banks. The extensive purchasing programs of both sovereign and corporate debt—combined with the sharp slashing of interest rates—reduced borrowing costs for corporate issuers to historic lows, especially in the United States. The chart below shows the constant-maturity 5-year yields of sovereign, as well as BBB-rated corporate bonds, denominated in dollars and euros.
US and Eurozone 5-Year Yields
The reduction in financing costs helped both share and bond prices, as can be seen in the chart below. The graphs for the bond indices show only the price components of the year-to-date returns, which exclude accrued interest and coupon payments. Given that US Treasury yields and prices—represented by the green line—have been moving mostly sideways over the past four months, the recovery in the two corporate-bond indices has been almost exclusively due to a reduction in credit risk premia, which were an almost perfect mirror image of these price-return series.
Cumulative Year-to-Date Price Returns for US Stocks and Bonds
The role of the US dollar: risky asset or safe haven?
Another quandary, which lent itself to differing interpretations, was the latest performance of the US dollar. At the end of July, the Dollar Index—a measure of the USD’s value against a basket of foreign currencies—recorded its worst monthly return in more than 10 years. Pundits were quick to point out that this reflected rising concerns about the bad economic performance in the second quarter of 2020 and the resurgence of COVID-19 cases around the world.
US Equities vs. Dollar Index Timeseries (left) and Weekly Returns and Correlations (right)
However, this explanation, as logical and appealing as it may seem, contradicts the role that had been attributed to the US dollar in previous weeks. In our recent blog post on The top 10 cross-asset correlations to watch, we noted how the dollar, previously mainly viewed as a barometer for the state of the American economy, was now perceived by many as a safe haven for investors from around the world. The charts above show recent returns of the STOXX® USA 900 versus the Dollar Index, which is plotted on an inverted scale in the left-hand plot.
Indeed, until the end of February, currency and stock market had been moving in tandem (as they had, in fact, for most of the past 3.5 years), which is also indicated by the strong positive correlation of weekly returns shown in blue in the right-hand chart. However, the severe liquidity concerns at the peak of the crisis in March turned this relationship on its head, as investors from all asset classes and regions liquidated their holdings and rushed into the perceived safety of USD cash. This is highlighted by the significant negative correlation of the green dots on the right, which represent the weekly returns since the beginning of March. In light of this latter interaction, the supposed “weakening” of the dollar could be then interpreted as an unwinding of those safe-haven dollar positions—essentially as sign that risk appetites are increasing again.
Not as straightforward as it may seem
The recent behavior of the US dollar shows that things are hardly ever as straightforward as some market commentators present them. That said, a bit of quantitative analysis can shed light on the inner workings of financial markets, as we have seen when decomposing and dissecting the recent performance of the US stock market. The latter hinted that the strong positive overall returns may simply have been a consequence of the crisis, driven by its major beneficiaries, rather than a sign of returning optimism and economic growth. We also saw how much of what we have experienced lately has been driven by, and dependent on, the extensive and decisive actions of the major central banks. And even if the funds for dealing with the immediate crisis were readily advanced by those big lenders, someone will have to foot the bill eventually. In other words, we are likely to feel the repercussions of this crisis for many more years to come.