Is the Bond Market Sending Out a Bleak Message?

Well I never thought it was possible for the second time so fast. That is, to see the 10-year US treasury bond yielding 2.5 per cent. And while investors have every reason to cheer that inflation I dead, they shouldn’t be so cheerful of the consequences of these low yields.

For one thing, record low yields usually are (but not always) a contrarian sell signal for a major market correction. At the height of the market crisis of 2008, the 10-year US treasury went from yielding 4 per cent to 2 per cent. As things got a little better, yields went back up to 4 per cent, but recently yields are at 2.6 per cent once again. While on the surface the current environment is not scary, nevertheless the bond market is signaling that things are not as good as they feel and that looking forward, investors are in for a bumpy ride.

Low bond yields are also a sign of low growth expectations or low profit expectations or both. However the profit picture is not bad. If anything else, profits at all US corporations rose to a new record according to Fed figures. So why is the bond market screaming a double dip if the profit picture is not bad? While the bond market doesn’t have to be right, low bond yields might also mean deflation expectations. Yes, most analysts’ and market commentators will tell you that deflation is not possible, but try telling that to the housing market. Also, Japan is a stark reminder that central banks don’t always save the day.

If we look at TIPS (Treasury Inflation-Protected Securities), bonds that pay based on consumer price inflation, the story is stunning. The real yield on ten year TIPS is only 1.0 per cent, while five year TIPS yield essentially zero and three year TIPS have a negative yield. There is absolutely nothing in the TIPS yield that says that we will get any inflation of any kind any time soon. If anything else, TIPS are telling us we are heading towards deflation coupled with a sustained period of low to zero growth. While this is not a deflation call, nevertheless it is close to it.

By the way, where is our V shaped recovery everyone talked about last year? The jobs picture in the US as well as Europe is not getting any better. And if one looks at alternative unemployment measures, then the picture is bleak. Is it actually possible to be bullish with almost 10 per cent unemployment? Is the bond market simply implying stagflation and below potential growth, coupled with high unemployment for an extended period of time?

But even If the answer to the above question is yes, why are profits so robust and why is everyone rushing to bonds for cover when they could simply invest in stocks? At the moment the Dow is yielding on average 2,94 per cent while the 10 year Treasury 2,6 per cent. Either stocks are very cheap or bonds are stratospherically priced or both. Well maybe because this time around low bond yields have nothing to do the market fundamentals.

The fed has been buying government securities for some time now. I addition, the Fed announced a short while ago that it will invest mortgage bond proceeds in log term dated bonds. Maybe anemic world growth and central bank purchases have been distorting bond yields leading us to a speculative frenzy for no apparent reason other than government intervention. I other words, maybe we have s distorted supply side situation and low yields have nothing to do with reality and thus, don’t portray what is actually going on.

So while stocks are cheap and investors should be happy, open market purchases by the Fed have produced a distorted yield picture and at the same time, an artificially gloomy picture in the bond market that has everyone confused and preventing stocks from gaining ground.However, brushing aside conspiracy theories, the ISM manufacturing index is still positive, but weakened again in July. So did ISM's new-orders indicator and second-quarter GDP growth was revived to the downside and there are probably more negative revisions in the pipeline. So there are many fundamental reasons why everyone at the moment is in a stale mate situation.

But the disconnect between low yields and relatively cheap stock valuations is not easily explained. There are plenty of convincing arguments and explanations by both the bulls and the bears. Market participants are either concerned about systemic issues, a typical weakening of the US and world economy or simply a decline in long term inflation expectations or none of the above.

Take your pick, but choose wisely; investors who answer the million dollar question pertaining to low bond yields will be the ones with the above average returns in this very complicated investment environment.

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