Friday, October 23, 2009

Some Thoughts on Buttonwood's Trifecta

Buttonwood’s column this week is typically thought-provoking. She starts with the observation that three major asset classes – stocks, bonds and gold – have all produced double-digit returns in the last three months. She then points out that this is not usual: indeed, it has only happened thrice in the past fifty years 1. And for good reason: the three asset classes have very different exposures to risk (equities are risky, bonds and gold are canonical safe havens) and to inflation (gold is a good inflation hedge, bonds are not, and equities lie somewhere in between). She describes various fundamental explanations (divisions in investor opinion; inefficient markets; central bank intervention; increasing risk appetites). And finally, she lays out her own explanation: liquidity.
Low interest rates are driving investors out of cash and into anything that offers either the prospect of capital gain or a yield that is higher than zero. Investors used to talk about a ‘Greenspan put’ that supported the stockmarket. This time there is a ‘Bernanke put’ supporting all asset prices.
I think that this is exactly correct, as far as it goes. But it doesn’t go far enough. Buttonwood leaves unanswered a host of interesting questions, such as: if there so much liquidity in the market today, why hasn’t it manifested itself in the inflation data? And why, on previous occasions when there was a lot of liquidity available (under, for instance, the Miller Fed), didn’t all three asset classes rally in tandem? Conversely, why did all three asset classes rally together in late 1982, a time when nobody could plausibly claim a surfeit of liquidity in the market?

The second question is the easiest to answer. Under Arthur Burns and then William Miller, realized inflation was very high and inflation expectations were well-entrenched. Asset prices reflected these fundamentals. Gold confirmed its status as an inflation hedge, rising from $35 (its pre-float peg) to over $800 over the course of the 1970s. In contrast, the fixed cashflows offered by bonds are very unattractive under inflation, hence bonds did horribly: 30-year yields rose from around 7.5% in 1970 to 15.5% in 1981. Equities merely treaded water, with higher nominal earnings cancelled out by higher discount rates.

The 1980s saw exactly the opposite dynamic. The Fed under Paul Volcker committed itself to fighting inflation no matter what the cost in terms of temporary economic pain. As a result financial assets enjoyed a golden run: stocks entered a 20-year bull market (to 2000) while the bull market in bonds lasted even longer (to 2008 – and counting). Meanwhile gold was pummeled, dropping all the way to $250 in 1999.

So far so good; all these are precisely what you would expect when changes in (Fed-sponsored) liquidity drive asset prices, first one way and then the other. And as theory dictates, the three asset classes never moved strongly in the same direction, throughout this lengthy period.

With one exception: the last quarter of 1982. Gold, stocks and bonds all rallied very sharply into the end of the year. What happened?

Here’s my theory, propounded as always with the benefit of hindsight. 1982 was the year that the markets finally ‘got’ Volcker’s plan. Tight monetary policy had already caused a short, sharp recession in 1980. 1981 saw a partial recovery, but then the economy entered a crippling double dip in 1982. Nonetheless Volcker kept policy relatively tight (certainly tighter than his predecessors would have done in the same situation). Gold rallied in expectation that this tight policy would hurt the economy and force Volcker to capitulate and ease rates 2. But Volcker stood firm. This gave stock- and bond-markets confidence that inflation was truly going to be beaten, and so it proved. Stocks and bonds continued to rally, while gold gave back its gains within a matter of months. And so it continued, for the next 20-odd years.

Which brings us to 2009. I agree with Buttonwood that the ‘Bernanke put’ (in the form of easy liquidity) is supporting all asset prices. But why don’t Treasury prices reflect this? Where are the bond market vigilantes?

I suspect the answer is that these days, bond traders, like the Fed, care more about wage and retail inflation than about asset inflation 3. And wage and retail inflation has been kept quiescent by the entry of Chinese labor into global commercial flows (a point I have made before, at length). That’s why the current flood of Fed-sponsored liquidity hasn’t entered the official figures yet; and that’s why bonds continue to be bid up.

Will it last? Or will bonds be the next great bubble to burst? We shall see.


# 1 Try as I might, I cannot replicate Buttonwood’s numbers for government bonds. The high in yields over the past 4 months was on 7 August; the subsequent low was on 7 October. Between those two (cherry-picked) dates, 10-year Treasury notes rallied by about 70 basis points, which corresponds to a return of roughly 6% in price terms. The price gains for 2-year, 5-year and 30-year Treasuries over the same period were 1%, 3% and 8% respectively. Given that Treasury issuance is overwhelming skewed to the short end of the yield curve, there is simply no way that bonds have returned double digits in the last quarter. Also, Buttonwood talks of a fifty year sample; this is actually meaningless, since the dollar was pegged to gold until 1971. But I digress; this is mere quibbling over numbers, and the arguments made elsewhere in Buttonwood’s column remain valid.

# 2There was also a large technical element to gold’s 35% rally, coming as it did on the heels of a 65% selloff.

# 3FX traders are not so accommodating; witness the continuing weakness in the dollar versus pretty much every other currency in the world.


  1. On further reflection, this post is just a drawn-out argument that stocks, bonds and gold should not go in the same direction, and if ever they do, it’s because one or the other of them is ‘mistaken’. In 1982, gold was wrong while stocks and bonds were right. In 2009, the jury is still out.

    Does this mean that the market is inefficient? Yes and no. Yes, in the sense that all three sets of prices cannot be correct. But no, in the sense that there is no arbitrage between the three asset classes.

    Buttonwood says “Either the deflationists or the inflationists should win the argument and force the other asset class into line.” I’m not sure I agree, simply because we don’t yet know what the final outcome – inflation or deflation – will be. Stay tuned.

  2. It appears to me as if inflation will remain subdued for a long time. The Fed can print all the money it wants but if the end user (retail consumer) doesn't have access little real economic growth will ensue.

    Therefore I believe the rally in equities will have a serious corrections and treasury rates will fall.

  3. Nice Blog. Keep posting more