Diverging EU equities and bonds

DESPITE the torrent of bad news that has hit the Eurozone, the equity markets keep bouncing back. With every platitudinous comment from a Eurozone minister that “everything is going to be ok” and that they have everything under control, the markets have rallied. At first glance, the rally in the STOXX 600 is particularly surprising considering how heavily weighted that index is in banking stock – a sector that has a very torrid time of things. And at the same time, Europe’s peripheral sovereign debt markets – the beast that central bankers and government ministers have been trying to placate – have continued to notch up new record yields and CDS spreads.

STOCK MARKET RED HERRINGS
So is it the cup half-full equity markets or the cup half-empty government bond markets of the European periphery?

To start, a high stock market is not an indicator that all is rosy in the economy. It can simply be a sign that this is perceived to be the case or can be a complete red herring and a sign that investors are scared to hold anything else – government bonds, currency or property for example. Despite this, politicians are often keen to maintain an artificially high stock market in order to vindicate their policies and in doing so create dangerous false economic indicators – such as in the case of recent European short selling bans.

“Basically it seems that bond markets are pricing in a recession and sovereign risk whereas the equity market is pricing in an economic recovery,” says Simon Furlong, a trader with SpreadEx. “Equity markets are still banking on emerging market demand to cushion any future lack of growth in the west,” he adds.

BOND BEARS AND EQUITY BULLS
So when you see a divergence between a bearish peripheral bond market and a bullish stock market, which should you take the greatest heed of? Debt markets have historically been more accurate than the equity markets in predicting the next boom or bust. In 2008, stocks kept on rallying on supposedly good news while debt failed to perform.

Angus Campbell, head of sales for Capital Spreads, points out that this time things are slightly different – while equities are getting ahead of themselves, it is some debt markets that are in real trouble: “Bond yields for peripheral European state debt is spiking, precisely because investors are nervous that they might not see their money back at all.”

If spread betters believe the peripheral bond market is correct, they should sell the current rally in equities. At the same time, they could also go long some government bonds to take advantage of the risk-off trade in certain bond markets.