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Stocks Rally but the Bond Markets aren’t buying

Bond investors are a different lot from those who buy stocks. They have to be since their market is many times the size of equity markets and a lot more of the world’s economic well-being is riding on its shoulders. So far the 20% gain in the stock market over the last few weeks has been greeted with indifference.

Back a hundred years ago, when I worked at Salomon Brothers, one of the late great bond houses under CEOJohn Gutfreund, I first understood the differences. Bondmen (and women) are less given to emotion, unperturbed by bad news and are only convinced when they see hard numbers in front of them. Rarely, if ever, is a trend in the stock market sustainable unless the bond market confirms it. Sure, the two markets can go their different ways for a month or two, but after that it is the bond market that calls the shots.

This week, for example, when the new U.S. Treasury Secretary Tim Geithner announced the Obama Administration’s plan to rescue the banking sector the stock market jumped 7%. However bond prices barely moved. A week ago, the Federal Reserve announced plans to buy over $300 billion in government bonds and over $700 billion in mortgage-backed securities. Bonds did react. Prices moved up for one day but since then have either come back to prior levels or moved even lower.

To be fair, some areas of the credit markets have seen some change. Mortgage- backed securities have seen rates drop as have mortgage rates overall but most of that move is attributed to the Fed’s plans to purchase some of that debt as well. Experts say the bond market, especially in the corporate arena, is still pricing in a high level of future defaults. Corporate bonds are so cheap (and interest rates high) that it has spurred quite a bit of buying from investors who are unhappy with the less than 1% -3% returns they are receiving in money markets and Certificates of Deposits (CDs). But it has yet to fuel a rally in corporate debt. This is a worrisome sign.

One of the major concerns of bond traders worldwide is the amount of debt governments are accruing in an effort to combat this recession. Each week in Europe, Asia and the U.S. governments are tapping bond markets, auctioning off increasing amounts of treasury debt to fiancé bail-outs, burgeoning budget deficits and other emergency spending. Bond investors are beginning to balk at buying these bonds. This week, for example, Great Britain experienced a failed debt auction and on Wednesday our own Treasury had trouble selling $34 billion of five-year Treasury notes. Other countries are running into the same problem.

Who can blame them? Bond holders fear that in the near future governments will be forced to raise ever increasing amounts of money, burying buyers in so much debt that investors will stop buying or demand higher and higher rates of interest to purchase more and more paper. Right now, for example, the bond market is watching Washington debate a historically high budget that if passed will mean additional trillions in government debt auctions.

There is also another danger that governments will “crowd out” the private sector who also need access to the debt markets. It has happened before. The more debt governments dump on the world bond markets, the more upward pressure is placed on interest rates across the credit spectrum. Private borrowers ranging from commercial entities such as corporations to consumer mortgage, credit card and auto buyers, not to mention areas like student loans, will have to compete (by offering buyers higher rates of interest) with governments to borrow.

In Europe, central bankers and government leaders alike are starting to worry about their mounting deficits. They are calling on America to practice restraint in our own borrowing. Next week the G20 group of nations will meet in London. It will also be the overseas debut of our own President Obama. No doubt he will hear much of what you are reading now from his counterparts across the world. I know for sure that the bond markets will be paying close attention to how he and the other nineteen national leaders will respond to investor’s fears. Let’s hope they are not disappointed.

Posted in A Few Dollars More, Macroeconomics