The US stockmarket turned down again last night. That’s always a bad sign in the aftermath of a crash. Stocks are supposed to bounce back for the same reason they crashed – mean reversion.

Of course, they did bounce back for a day. And a half. But then the US government auctioned off some new debt. The auction did not go well and the government had to offer a higher interest rate. The rate didn’t reach Monday’s spike, which triggered the panic. But it was enough to get stocks to turn down for the day.

This adds weight to the narrative we’ve been discussing. The idea that higher interest rates in the bond market are a problem for the stockmarket.

But it doesn’t resolve my riddle. How can the falling bond market trigger a crash in the stockmarket if investors buy bonds when they sell stocks? Each time stocks drop, bonds recover.

Except when they don’t. Analysts at the big investment banks are pointing this out in their cleverly worded ways.

Correlation between stocks and bonds has gone, reports Societe Generale. It’s usually at around 0.4, but it’s at 0 for the last 90 days. In other words, stocks and bonds have fallen together quite often in the last 90 days, instead of moving in their stabilising opposite directions.

But why?

Perhaps the answer to my riddle lies with central banking. If central banks are set to raise rates, that could sink the bond market and the stockmarket at the same time. The external influence of a market manipulator makes a breakdown possible.

What makes it especially plausible is that we’ve been living in the opposite environment these last few years. Central bank monetary flooding lifted all boats. Stocks and bonds went up together as quantitative easing (QE) pumped them up. Now they’re going down together as central banks exit the market.

But that just leaves us with another riddle. Rising rates should slow inflation. And that means central bankers should be able to control this whole process. They should be able to raise rates at the pace the economy can handle. Without triggering a stockmarket rout and without letting inflation get out of hand.

At the slightest sign of trouble, they can just stop raising rates or reducing their QE.

There’s only one place that is not possible. And I’m working on a report to expose it.

A new kind of stagflation

But there’s another possibility that explains the strange behaviour of the market. Stagflation. Only this time, the stagnation reference refers to the stockmarket instead of the job market.

Perhaps the odd relationship between the bond market and stockmarket is signalling that the central bankers cannot raise rates without triggering a stockmarket crash. Meanwhile, inflation could continue to rise thanks to a tight job market and performing economy.

Central bankers will be forced to choose between controlling inflation and keeping the stockmarket elevated.

CNBC reports that traders are already betting the Federal Reserve will have to slow its planned interest rate increases in the aftermath of the recent stockmarket crash.

Remember, the crash was triggered when a surprising wage growth triggered fear of inflation. That suggests people believe the Fed is more concerned about stocks than the inflation rate.

If they’re wrong, the stockmarket could be in for a dreadful surprise.

Not all bonds are created equal

The SocGen analyst mentioned above also pointed out that US stocks with bad balance sheets declined more than double the companies with good ones. A further conformation of the bond crash triggering a stock crash narrative.

This also hints at what’s to come in the next few years if bond markets do fall.

The weakest hands will be in trouble. Those struggling to pay their debts.

Carillion, for example. How many companies in our economy are only solvent thanks to extraordinarily low interest rates? Who will be exposed when rates rise?

If the fallout is bad enough, the sudden onset of defaults can trigger a major crisis. Last time round it was US sub-prime borrowers. The European sovereign debt crisis was never allowed to play out.

Who will be next?

I’ll let you know soon.

Until next time,

Nick Hubble
Capital & Conflict