Treasuries Say Stocks Vulnerable

The drop in yield Monday of the 10 yr Treasury note and the 30 yr bond was truly stunning. Stunning for the size of the drop in both and even more stunning considering the low absolute levels of each already. The 30 yr dropped 14 basis points and the 10 yr 11 BPs to 2.56%.

The significance of the drop though were the reasons for it. While the true reasons are somewhat elusive it is hard to think of a reason that is either positive for the economy or the stock market.

Ironically as the US economic reality deteriorates, US obligations become more desirable to foreigners. This is because of the amount of the world economy accounted for by US GDP and even more importantly the fact that investors throughout the world know that potential changes in US demand will have a knock on effect for the entire world economy.

There is no doubt that another recession here would reduce exports from China and elsewhere, hampering growth there and around the world. No matter how bad it gets here it will be worse elsewhere for a good portion of the rest of the world.

What is happening now with the rates on US obligations is of historic proportions. The yield on these obligations did spike down even further two years ago during the financial crisis, but that would be expected in the face of the threatened financial collapse we almost had.

Today in the absence of such a threat it looks likes its headed back to the same level. The culprit this time appears to be the threat of deflation. Although inflation rates have trended downward for a while, at present there is no catalyst to tip the balance into a deflationary spiral. The only catalyst that could cause that is a recession. A recession of even moderate scale could easily push us over the line into deflation.

At this particular point in time deflation and recession have become intertwined. To predict one is to predict the other. You can also add the declining yield curve to this twosome as it is a precursor to both.

The bond markets seem to be signaling the onset of recession with a fairly high probability, well above 65% if today is any indication. Economists as a group seem to be somewhere around 40% and stock market investors around 30%. This low expectation of recession makes stocks very vulnerable, should it become crystal clear a recession is at hand.

Economists aren’t all saying 40%. Some say more, and some say less. Recently ECRI WLI reversed its downward trend and is now pointing upward, while at the same time its managing director is now warning of the possibility of recession, a change in stance for the organization. Some of the components of its LLI indicator have headed south recently perhaps accounting for ECRI’s shift in tone.

A lack of final demand has been pervasive in the economy ever since the upturn started in the spring of 2009. At the same time employees have not been rehired and businesses and consumers have continued to delever. With the recent GDP revisions the personal savings rate has been increased.

It has now become clear there is a new set of feelings, or propensities, toward spending and investment by both consumers and businesses. This raises the issue of whether there is enough underlying demand in the economy to lift us out of recession, beyond the previous peak, despite the fact many economists have already called the end to the recession. Importantly, the NBER the official body that makes the call for recession dating has not reached a verdict.

All this contributes to a feeling some have that something is not right with the economy. The stock market’s failure to internalize this uncertainty raises questions about its forward trajectory as well.

Perhaps this latent vulnerability has given rise to discussions recently of the Hindenburg Omen that have percolated up from the blogosphere to the mainstream business media. I don’t discount its validity. As long as its large number of false positives , are taken into account it has a useful role as input. It apparently has had no false negatives, a powerful reason for using it to confirm a negative outlook hypothesis developed independently.

Technical analysis aside, the market seemingly is not yet taking into account the preponderance of clear negative economic data over the last few weeks. With only negative news expected to unfold in coming weeks, it is reasonable to conclude there is a possibility of a sharp and sudden decline in the stock market.

BarryZee

Advertisements

One Response to Treasuries Say Stocks Vulnerable

  1. Bruce B says:

    The possibility of an ominous outcome exists. The chart linked to below shows clearly what happened last time the 30 year was at these levels. The bond market may be forecasting more than the normal “low growth with possible deflation” that we hear so much about from the punditry.

    http://quicktakespro.blogspot.com/2010/08/chart-of-day.html

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: