Insights & Advice

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What is the bond market telling us?

I’ve got a lot of respect for the bond market. After all, it’s much bigger than the stock market with a lot more money riding on making the right call on the markets. It is truly the Big Dog while we in the equity markets are the tail. Recently, bond prices have shot up while interest rates have plummeted. What does that mean for the stock market?

Back in the day, when rates dropped, stocks rose as investors anticipated a strong economic environment, which was reflected in higher stock prices. That relationship fell apart in 2008. The financial/debt crisis saw bond, stock, commodity and real estate prices drop while only cash and Treasury bonds did well. Since then the correlations have been all over the place.

The bears argue that the decline in the ten year Treasury bond yield to 2.50 % along with the 0.11% yield of the five-year, inflation protected Treasury bonds (called TIPS) is a clear indication that we are heading for deflation and a double dip recession. They point to a 9.5% unemployment rate, 74.8% capacity utilization, falling home prices, durable good orders that are down 20% from the peak, rising unemployment claims, high historical private sector debt levels and equity prices down 30% from their highs as proof of their argument and the reason investors are fleeing to Treasuries for safety.

I argue that the economy is growing slowly and will continue to move higher in fits and starts as it has since last July, but the recent weakening in the data has sent investors scurrying for cover.

It’s called the ‘Fear Trade’ because many investors, given the above litany of bad news, have few choices. They can stay in cash, which is yielding practically nothing or they can take their chances and invest in a highly unstable real estate market or an equally volatile equity market. Go to governments. In an environment like that, a 2.5% government bond doesn’t look half bad.

“But what about the deficit, what about the economic stimulus package, all the money the Fed has pumped into the economy?” demanded a client, sitting with me on the lawn at Tanglewood last weekend. “Isn’t that inflationary?”

He was angry and there was no stopping his passion for the subject.

He represents the opposite camp, those who believe buying bonds are a trap. They are afraid of inflation and wary of higher interest rates in the near future. They want to reduce the deficit now, put a stop to all this crazy spending immediately and start to reduce the deficit. They are adamantly opposed to any additional stimulus that the government might be contemplating.

“Those people buying bonds are crazy,” he concluded, just as the music dropped to a new low.

The sharp comments and deadly stares from all around us cut off my reply but if I had had the chance I would have told him what I believe the bond market is telling us.

When you take apart the current projected budget deficit of $1.3 trillion, you find that $700 billion (54%) is a result of the Bush Era tax cuts, which are sure to be reinstated next year. Another 25% ($320 billion) of the deficit is a result of a decline in tax revenues, caused by the Great Recession. Iraq and Afghanistan, account for $200 billion (15%), which leaves $50 billion (4%), due to Obama’s recovery measures.

So am I really steamed because the administration wants to spend 4% of the deficit to reduce unemployment? Not likely. If the economy continues to grow (as I think it will) the missing tax revenues will be replaced by a higher tax intake. At the same time, the Obama Administration is only waiting until after the November elections before they and the new congress overturn the Busch tax cuts. That will take care of the lion’s share of the deficit (79%). Although Afghanistan remains, the scheduled withdrawal from Iraq next year will cut another 7% off the budget as well. And finally, if the Republicans gain seats and the Democrats lose their majority, there is a possibility that very little in the way of new legislation (spending) is actually passed over the next two years.

So while stock jockeys are gnashing their teeth over too much or too little inflation and government spending, the Big Dog over in the bond market might be betting on an entirely different scenario.

Posted in A Few Dollars More, At the Market