Why Financial Markets don’t Follow the Old Rules Anymore

My favourite moment of the working day is doing a dot-to-dot. And it happens every morning, after booting up my computer; I look across the various asset classes, and start connecting the dots.

After the first few screens, it becomes progressively easier to predict what is coming next: dollar down = risk on, equities up = bond prices down, risk off = metals down. But joining the dots has gone askew recently. So from the starting point of mortgage rates to a crude conclusion, here's how joining the dots isn't as simple as going from A to B.

Whether financial markets float your boat or not, what is a useful thing to know if you have a mortgage, want to buy a house, or want to refinance, is the biggest influence on mortgage rates. And while logic dictates that a 30-year government bond would be a decent guide for a 30-year mortgage rate, that would be somewhat inaccurate. It is actually a 10-year treasury bond:

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It is also fair to say that mortgage rates are low when times are hard, with low interest rates to stimulate borrowing and bond yields driven lower by a flight to safety.

It is also fair to say that as optimism in the economy improves, greater risk appetite should mean bond yields (and mortgage rates) should rise, and equities should see a corresponding rally.

And we have. That is, until the past few months, when we have seen the two diverge:

So what does this mean? Well, at the crux of it, one of the markets appears to be wrong.

Falling bond yields indicate the battening down of hatches, while equities indicate better times ahead. And what is doubly interesting is that commodities - and specifically oil, which has taken part in the risk-on trade for much of the recovery of the last few years - is diverging also:

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Which leaves us at a fascinating juncture. Either commodities/bonds are correct, or the equity market is. Regardless, one is lagging, and will likely experience a significant correction in the coming months - be it equities tumbling, or commodities/bond yields melting up. Or even a bit of both.

Either way, today sees the S&P500 within grasping distance of a new record high, while on the same day mortgage rates are making record lows. The dots, for now…….do not connect.

By. Matt Smith