»The Daily Reckoning by Bill Borner

The Disconnect between the Stock and Bond Markets
5 NOVEMBER 2011

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
The month of October saw a strong performance for stock markets, as risk appetite slowly returned to the market. While the months of August and September saw large market falls due to debt concerns in the Europe and America, many of these fears appeared have receded in October.

For many markets, October 2011 was one of the best performing months in recent history. Global stock markets rose by an average of around 10% in that month, which is a huge gain. In general, a market rise of 10% in a year would be considered strong, so to achieve that in a month is quite unheard of.

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As the events of the last week have shown us, the Greek debt crisis is far from over. The rise in markets during October was largely due to perceptions that the Greek crisis would be contained, and perhaps even solved. As European politicians negotiated with one another, the stock markets continued to gain momentum.

As of now, we have little idea of what will happen to Greece. There is a possibility that the deal reached the previous week will not be honored. There is also the possibility that the current government will not survive. The stock market expectation that this would be solved has clearly not materialized.

In stark contrast to the performance of the stock market in October, the bond market saw things differently. If we look at the performance of government bonds of indebted Eurozone countries over the month of October, the figures showed a worsening of conditions, rather than an improvement.

The way in which we will measure the bond market performance is to look at the yield spread between the 10-year government bonds of an indebted country over the 10-year German government bond. An increasing yield spread indicates that the perceived default probability has increased, and thus conditions have worsened, rather than improved.

Here are the figures: Over the month of October, the yield spread of Italian over German bonds increased by 0.7%. Spanish bonds saw an increase of 0.3%, Portuguese bonds saw an increase of 1.3%, and Greek bonds saw an increase of 1.9%. All the indebted Eurozone countries saw their government bond yield spread over German bonds increase in the month of October.

Thus, the perceived default probability for indebted Eurozone countries increased substantially in October. The deterioration in the bond market stands in direct contrast to the strong stock market performance. While the stock market seemed to suggest that things were getting better, the bond market said the exact opposite.

It is not just the yield spread change that is concerning. The actual spread level is also very high for these countries. Currently, Italian bonds yield 4.3% over German bonds. For Spain, this figure is 3.5%; for Portugal, this figure is 9.8%; and for Greece, this figure is a whopping 23%.

Given the large disconnect between the stock markets and bond markets, which is correct? Should we put more weight on stock market optimism, or bond market pessimism? If our goal is to evaluate the likely impact of the Eurozone debt crisis, the bond market is what we should be listening to, rather than the stock market.

Stock market investors tend to be a lot more diverse, and most of them have no direct stake in Eurozone debt failures. On the other hand, bond market investors stand to directly suffer in case of a Eurozone default. Thus, the bond market is more likely to accurately reflect the possibility of a Eurozone default, as compared with the stock market.

Whenever we see news about a possibility of European deal or something else that would fix the crisis, we should look to the bond markets for what the market expects to occur. While stock markets may fluctuate wildly, the bond markets are more stable and more likely to reflect true probabilities, given that the investors are more directly affected.

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