You can read this in one of two ways. You could see it as a sign that the 'reach for yield' has pushed bond prices up too far, and that investors are too complacent about the still-wobbly health of corporate America. Or you could read it bullishly; maybe the wisdom of crowds, as embodied in the corporate bond market, is telling us that the downside risks to US companies are smaller than we think.
The historic evidence is wonderfully neutral between these two narratives. Since 1997, the spread between BBB yields and five-year Treasury yields has had precisely no ability to predict equity returns; the correlation between this spread and subsequent six-month returns on the All-Share index has been 0.02. A low spread is, therefore, as likely to be bullish as bearish for shares.
However, history tells us that the level of bond yields does tell us something about subsequent returns. Controlling for the dividend yield on the All-Share index, both BBB yields and five-year Treasury yields are statistically significant predictors of six-month returns. There's good and bad news here.
The good news is that, other things equal, lower BBB yields are associated with higher subsequent equity returns. This is consistent with the wisdom of crowds hypothesis that bond markets tell us something about the health of US companies, which is not immediately embedded into equity prices.
The bad news is that low Treasury yields lead to low expected returns. In one sense, this is mundane. Lower expected returns on bonds should mean lower expected returns on equities, unless the equity risk premium varies strongly inversely with bond yields. In another sense, though, it is surprising. This relationship, remember, controls for dividend yields, so it seems that stock markets do not fully discount the bad news about expected equity returns which lies in low Treasury yields.
On balance, these two factors are slightly positive for equity investors. If the post-1997 relationship between yields and subsequent returns continues to hold, the All-Share should rise 3.3 per cent in the next six months. To be less precise but more accurate, it points to a slightly better than 50:50 chance of the market rising.
Sure, this is a weak signal - although we shouldn't expect any better once we leave story-telling behind and look at the noisy data. But it is at least a positive one.
