Bond Market, Stock Market See Two Different Economies

For the past few months, the stock market has been behaving like a reveler who's had just a little too much to drink, and the bond market has been behaving like the guy who wants to take away the stock market's car keys.

We should probably listen to the bond market.

The broad S&P 500 stock index has rallied 22 percent since early October, recently hitting its highest level since early July. The narrower Dow Jones Industrial Average recently hit its highest mark since May 2008. And the technology-laden Nasdaq Composite index recently climbed back to a level not seen since December 2000.

The stock market is suggesting that American investors are shaking off many of the fears that hammered stocks last summer and early fall -- namely, Europe's debt mess and our own shaky economic recovery.

The bond market, on the other hand, suggests those fears are alive and well.

The 10-year Treasury note is a key gauge investors watch to measure investors' appetite for risk. When bond prices are high, it means that investors are scrambling for the relative safety of U.S. government debt. When bond prices are low, that often means people are putting money in riskier assets, or at least that they're worried about an outbreak of inflation, which often accompanies stronger growth.

Bond prices right now are very high. One way to measure Treasury bond demand -- a way that most normal humans can relate to, anyway -- is by looking at the bond's yield. This is the interest rate you’re getting paid to lend money to Uncle Sam. When that interest rate is low, it means Uncle Sam is having an easy time getting you to lend money to him, which means lots of people want to own his bonds.

Recently the yield on the 10-year Treasury note was a shade below 2 percent, not far from the lowest levels since at least the 1940s.

When bond yields are low, it means that bonds are expensive to buy. It means investors are willing to give up some future interest income in order to get an investment that will hopefully not take all their money and set it on fire, as the stock market has a nasty habit of doing.

In fact, demand for Treasurys is so strong that investors in most Treasury debt are accepting interest rates that don't even keep up with the Fed's targeted inflation rate of 2 percent, as Bloomberg noted on Monday.

Bond investors apparently are not at all worried that a money-pumping Fed or some future sudden burst of strength in the economy will drive inflation through the roof and make their low-yielding bonds worthless.

The stock market may not exactly be priced for runaway growth, either, but it is priced for faster economic growth than the GDP growth rate of 1 percent to 2 percent that is likely in the first quarter of 2012, Lombard Street Research analyst Charles Dumas wrote on Monday.

The stock market is not a proxy for economic growth -- corporate profits can grow strongly even when the economy is sluggish, and that can help lift stocks. But market-watchers are increasingly worried that companies have managed to squeeze all the profit growth they can get by laying off workers and closing plants. That means they'll need actual sales growth -- which does depend on a stronger economy -- to keep profits, and the rally, growing.

This is not the first time the bond and stock market have sung different tunes about the economy. Last spring, a noticeable disconnect between bond yields and stock prices signaled the near-term top in the stock market, as Matt Phillips of the Wall Street Journal noted presciently.

The gap between stocks and bonds is far, far bigger today. It is also arguably wider than it was in late 2007 and early 2008 -- another period in which bond yields fell well in advance of stock prices falling.

The bond market could be sending a false signal this time. High bond prices today at least partly reflect expectations of another round of bond-buying by the Federal Reserve, as Bloomberg suggested.

But we won't get another round of bond-buying from the Fed without more disappointing economic data, and the bond market suggests we could be due for some disappointment.

Comments

[FreedToChoose]

11:13 AM on 02/09/2012

Bonds, carefully chosen are an appropriate part of a portfolio, be it personal or retirement. There are bonds available yielding up to 5% with maturities of less than five years. Search 'bond market' and check it out.

[Jon LoGotti]

06:42 PM on 02/09/2012

He's referring to US Treasuries, specifically the 10 yr, which are what all bond prices including corporates high yield and other bonds like MBS are based on. If bond prices are high, which means interest rates are low, then the divergence between the 2 is very telling for future prospects. Bond prices are high for a number of reasons including the Fed buying long-term Treasuries to keep borrowing costs low, moving flowing into Treasuries from Europe because of the conditions in Europe and lastly because investors are anticipating another round of QE from the FED, which explains why stock prices are elevating on extremely low volume not seen since 1991. Buy the rumor, sell the news. Bonds are also reflecing that the US recovery is not on sound footing, meaning that people prefer to hold safe securities, even if the return is negative after inflation, because they think that corporate profits will not generate the kind of returns like they did last yr due to a recession in Europe, a slowdown in emerging markets, a higher dollar and less leeway to fire more employees since they can no longer fire people and are squeezing them with longer hours and more work.

[FreedToChoose]

07:33 PM on 02/09/2012

You understand that and I did, too. My comment was prompted by a friend who did not, who thought it referred to bonds in general. My point is, probably too indefinitely made, that there are so many bond and bond like instruments that what is happening in Treasury bonds is not reflected in the general bond market. Thanks for noting my too loosely made point.

[Jon LoGotti]

06:42 PM on 02/09/2012

If money is not moving out of bonds and into more riskier assets like stocks, then there is concern and doubt over the sustainability of the recovery in the long-run. Stocks, on the other hand, elevate due to low volume and anticipation for more easing from the FED which is also why Treasuries are higher in price. If the FED actively is buying more Treasuries, decreasing the supply to push investors into riskier assets, then bond returns will be lower but they can easily bid those bonds to the FED in return for higher prices.

[FreedToChoose]

07:36 PM on 02/09/2012

As above, my point was poorly made. The general opinion among unsophisticated investors is that bond yields are only slightly better than CDs. There are many high quality public bond offerings which provide yields of four to five percent, something we on fixed incomes find reassuring when combined with stocks and mutual funds is a balanced portfolio. Thanks for your thoughts.

[MSROADKILL612]

03:23 AM on 02/09/2012

If the reporter knew his stuff as he claims, he would have educated folks in a tricky but fundamental fact

he seems to make it worse by using yield & price almost interchangeably

there is a market for bonds - so if u have a 100k 10yr bond at 3%, & the market yield goes down to 2% - folks will pay a premium for u 3% bond - so the price/value of your bond goes up. its an inverse relationship between current yield & price on the market of existing bonds

[MrSavage]

03:23 AM on 02/09/2012

That's one way of looking at it. Another is that the Fed is buying treasuries thus keeping the interest rates low. If they ever decide that inflation is getting out of hand and try to stop the printing then interest rates could jump. Also stock markets often do quite well in an inflationary environment.

[Henry]

09:19 AM on 02/09/2012

Imagine an administration like Mitt Romney's getting tough with the PRC forcing a market revaluation of the Yuan that put the Yuan at 4 to the dollar instead of 7 to the dollar. Ouch that would touch off not only inflation but would repatriate a lot of bonds (now held by the PRC) and both impacts (higher costs for imports and more domestic absorption of domestic debt repatriated) would drive up interest rates at a minimum of 6% at the fed funds level and the rest would reset with the one-year Bill at 6.12% and the long bond at 7.5% (for example. Ouch... for the bond-holders.

[Jon LoGotti]

06:49 PM on 02/09/2012

That would also decrease the value of their foreign exchange reserves which are mostly in dollar-denominated assets. A higher yuan would cause more inflation in the US, that is true, but would also level the playing field where we, if the Chinese allow it, could export more goods and services to their economy since a higher yuan would give them more purchasing power. China is the largest holder of foreign bonds. Most US Treasuries are held domestically, pension funds insurance companies MMFunds et al, and the largest holder is the FED. The Fed controls the Fed Funds rate and if the rate is set at .25% until 2014, then they will keep pumping money into the fed funds market in order to sustain their target rate. There are both pros and cons to a lower dollar and higher yuan and the yuan has been appreciating, albiet slowly, against the dollar every year, a 6% increase last year alone. It's the dollar that is declining b/c of extremely low interest rates and growth prospects which causes hot money to flow into those emerging economies where they have to buy dollars to keep their currency at its current level and not cause an immediate destruction of their export base.

[Janzee12000]

09:00 PM on 02/08/2012

"We should probably listen to the bond market." No truer words ever spoken..

[DismayedRepub]

06:38 PM on 02/08/2012

The only reason U.S. Treasury bond yield is so low is because the FED comes in and lowballs the bids. The Treasury doesn’t have to sell the bonds to bidders that want a higher interest rate and they are forced out of the auction. The interest rates are kept artificially low and this is indeed a false signal.

[Note1234]

02:25 AM on 02/09/2012

It's the highest bid that wins at an auction. Not the federal gov't but the FRB Corp. (not Federal; no Reserve; not a Bank) that makes the highest bid (wants to pay the most) and thus willing to accept lowest yield (interest rate). It accepts essentially zero ROI because it got its funny money for free. It crowds out legitimate bidders who had to expend effort for their money and thus require some ROI.
The natural free market pricing mechanism of "price discovery" is obliterated by the central planning actions of the FRB Corp. It is essentially setting or fixing the price and interest rates without regard to free market forces.

[DismayedRepub]

02:35 AM on 02/09/2012

Yes true. I was trying to explain this in terms of yields and avoid the complexity of “Discount Coupons”. This can be confusing to people unfamiliar with how T-Bonds are sold. If people are interested they can google or wiki it. I think my money is much better spent down at the local coin store.

[MSROADKILL612]

03:36 AM on 02/09/2012

u copped some flak 4 this - but its fishy to me too - i dont get it

would rather punt on a non fiat, unindebted currecy like the saudi or the oz or the norway - than a known crap currency - "fiat" or not.

why on earth is anyone buying them? even so - cant see them holding them for long if they are smart. The yields are way less than true inflation (due to debasement), with worse to come

[DismayedRepub]

08:36 PM on 02/09/2012

NOTE1234's explanation is more technically correct than mine but we're both on the same page. I was talking in terms of yield because that is what the article was talking about.

Bonds are sold as discount coupons, say you buy a $100 bond for $95. At maturity get cash it out for $100 and net a $5 profit, this is the yield. If you bought the bond at $98 you'd only profit $2. This is how the price of the coupon goes up when the yield goes down.

Bond mutual funds are priced by the coupon price and as yields are historic lows, the price has nowhere to go but down. I can't understand why anyone would want to buy them either. I had a bunch off my 401 in Fannie & Freddie and sold them off in early 2006. I haven't bought any bonds since.

[bohemiangrooves]

11:55 AM on 02/08/2012

A lot of people here seem to think we are still on the gold standard. It's fiat currency not backed by anything people. There is never a risk of insolvency.The market doesn't set interest rates, the Fed does for its stated policy goal. A lot of Friedman supporters I guess still thinking that QE means expanding the money supply and driving down the price of the dollar. Several trillion in QE and yet the price of the dollar remains relatively unchanged (about a dime lower...). Inflation hurts the dollar and inflation comes from demand in the economy, not supply (unless its the supply of oil, then maybe a little inflation).

[DismayedRepub]

07:08 PM on 02/08/2012

The only reason the dollar remains relatively unchanged is because the other currencies are being debased as well. It is a race to the bottom. Now if you compare the dollar or euro to gold which holds its value, the dollar has lost almost two-thirds of its purchasing power since 2006. Four millennia of history is littered will the wreckage of civilizations that have destroyed their currency.

[MoMick]

12:39 AM on 02/09/2012

What currency currently in use is backed by gold? Not being a jerk, just asking.

[bohemiangrooves]

08:39 AM on 02/09/2012

Which currencies are being debased? The CA dollar? It's been hovering at par with the US dollar, which is historically high for the $CA. The Yen? The Japanese are busy selling Yen in the forex trying to debase it against the $US. The Euro? On a steep ascent against the $US since April. The Renminbi? The Chinese continue to buy heavily in the forex to keep it cheap against the $US.

[Jon LoGotti]

06:55 PM on 02/09/2012

Are you kidding me? QE drives down long term rates to push investors out into the yield curve by buying up more Treasuries, therefore decreasing the supply and increasing valuations relative to risk assets. The dollar has been declining against every major currency since the FED started QE and the only time it has risen is when carry trade positions are unwound and people seek a safe haven asset like the US dollar or Treasuries. QE does increase the money supply and it does also dilute the currency. Trade wars? Ever heard of that? We can also import inflation and cost-push inflation from higher oil prices also hurt the economy which is a reaction from QE, to influence inflation expectations. QE is all about driving the dollar down. That is what monetary policy does. It also pushes investors into riskier assets to cause a wealth effect and to control inflation expectations while the currency is diluted or used for carry trade purposes. That is ECON101

[bohemiangrooves]

09:07 AM on 02/10/2012

Ridiculous. Monetarism is dead. The Fed always sets the rates and payment is never an issue (unless politics become involved. Trade wars?? It's flexible exchange rates. QE does not dilute the currency, that's old-school hogwash. Explain to me how its expands the money supply? I don't see any increased lending going on. Extra reserves do nothing for increased lending. No more money in the system. Your textbook econ 101 was probably written by a Friedman adherent, but as even Nixon said, we're all Keynesians now.

[laurieanichols]

11:45 AM on 02/08/2012

If the the companies have squeezed as much profit from their own internal manipulation of inventories and labor cost cutting and now are being forced to face the music that progressive economists have been repeatedly shouting out from the roof tops, that consumer demand is depressed because of job cutting, you would think that the companies will hopefully have to bite the bullet and take some of the billions that they have been sitting on and re-invest it into the domestic economy to force consumers out there back to their job of consuming. Why does it seem so simple and yet everyone makes it so complicated? Especially the gurus at Wall Street and their GOP counterparts? The American consumer drives our economy, when the average middle income worker is happy the land is happy, you don't need a PH.d to figure that out.

[MrSavage]

03:30 AM on 02/09/2012

"you would think that the companies will hopefully have to bite the bullet and take some of the billions that they have been sitting on and re-invest it into the domestic economy to force consumers out there back to their job of consuming. Why does it seem so simple and yet everyone makes it so complicate­d?"

The short answer is that they see the storm coming and are hoarding money in hopes of surviving. Everyone knows that the current level of government borrowing/spending cannot possibly last and there will be massive cutbacks. Would you like to have just finished constructing a new production facility when this happens?

[rotorhead1871]

10:20 AM on 02/08/2012

bonds=short the dollar...get it yet......hello inflation!!

[bohemiangrooves]

11:44 AM on 02/08/2012

tell that to bill gross

[rotorhead1871]

05:12 PM on 02/08/2012

bill who??

[DismayedRepub]

07:08 PM on 02/08/2012

long the gold & silver

[rotorhead1871]

10:05 PM on 02/08/2012

roger that...

[Note1234]

04:28 AM on 02/08/2012

Bond market is distorted by FRB Corp. buying bonds with funny money.
FRB Corp. wants to pay as much as possible when it buys bonds.
It got its money for nuttin. No sweat.

[DismayedRepub]

07:09 PM on 02/08/2012

And the chicks are free.

[frank1946]

12:07 AM on 02/08/2012

Hey Boss, we need another $ 1.2 Trillion on Mar.1........................Just do It !

USA is Insolvent...............No Liquidity.....................QE 1, 2, 3, 4, etc.

Trust Me !

[rotorhead1871]

10:17 AM on 02/08/2012

they are just getting going.........you will see QE5, ..6, 7, 8 ,9.........gov will do whatever it takes to hold inflation to 2%...they will never accept deflation....the dollar must inflate significantly...to cover the interest and debt......short the dollar...NOW...

[DismayedRepub]

07:10 PM on 02/08/2012

To keep things simple I use the notation QEn+1.

[nothingchanges]

11:46 PM on 02/07/2012

Simple question.

How much credence can you give to "economic indicators", provided by a government, during an election year, when the politicians who run it, are held in the lowest esteem in history.

They wouldn't "lie" to us..................................would they?

Government, and those who now run it, have a vested interest in making the economy look as good as they possibly can, this year more than any other I can ever remember.

That alone, is enough to make ME nervous.

[Littleprairiehouse]

12:25 PM on 02/08/2012

Touche'

[PotomacOracle]

10:39 PM on 02/08/2012

Co-signed

Faved already a Fan

[pinetrale]

11:08 PM on 02/07/2012

With the european finanical crises percolating for months now a lot of their money has found a home in US bonds, especially liquid treasuries, and some into US stocks. So if and when that problem is settled, they will likely pull the money out of low yielding treasuries and plow it back into stocks, foreign stocks and chase the US stocks as well. If growth above 3% returns, so will inflation, and again stocks beat inflation more reliably than bonds. Stocks have been out of favor so long, people just don't want them and from a contrarian point of view thats a good time to buy. Of course the issue of an exogenous event, such as Iran cannot be factored into this so there is still risk involved. Taking risk, means, if you win, you should get rewarded, or has the market so changed?

[Jon LoGotti]

07:02 PM on 02/09/2012

Stock volume at 1991 levels. That means less money is flowing into stocks and the melt-up in stocks in due to very low trading volumes. Treasuries are rising for a number of reasons including what is going on in Europe. We have been decoupling from Europe for some time now and the divergence between stocks and bonds has been very telling and confusing since credit markets are usually right since the cash flow is recurring, where as stocks are more of a bet on anticipation of either more easing from central banks, higher profits (which peaked last year and will be much lower this year) and growth expectations, not from only the US but from emerging market top-line growth. That is where 40% of earnings came from last year on the S&P corporates: Emerging markets are growing at a much faster pace, although they have slowed.

[pinetrale]

08:39 PM on 02/09/2012

well for the better I think Bernacke has eliminated the Greenspan put, so now stocks must go up do to organic earnings growth and bullish bets on that. It is a new invresting environment from the Clinton and Bush years. The complicator is the advent of high frequency and overall "trading" versus long investing and tradtional shorting, and also the multiplication of hedge funds, derivatives, and the ETF's. Its still going to be a battle between traders on volatility and long holders but the fed is not as critical now as before for gains.

[jcaunter]

08:12 PM on 02/07/2012

It's always a bit shocking seeing "news" that I've been aware of for months turning up in the MSM as if it were fresh and new. But then I suppose that's the sort of psychological dislocations one can expect when primarily utilizing the objective independent media for useful information, and only using the corporate MSM outlets for the occasional sIumming.

[niumarmion]

07:48 PM on 02/07/2012

This article is not really telling us anything, such as, is the news of a recovery false. Will the value of the dollar plunge? Does is mean that there are trillions of dollars in mortgage debt still waiting to be de-leveraged? What will happen with Iran or with Europe? What is the effect of a permanent transfer of jobs to China?

[mickt]

07:02 PM on 02/07/2012

This is presented as if it doesn't make sense, however it does. The FED loans out money at about 0.25% to the banks against a security, nothing better than a AAA treasury bond as a security. Therefore leverage that about 20:1 and the real rate of return is (2% yield - 0.25% interest)*20 leverage = 1.75*20=35% return on investment. Only possible if you are a bank.

This is why the FED are keeping rates so low, they can generate huge profits for the banks to "earn" they way out of the hole they are in, while keeping the governments interest rates low until tax income returns to normal. The down side is that as soon as bond rates fall or the FED rate rises there will be a collapse in this trade. But we know it won't happen until 2014 because the FED says it won't.

[Durrrrrr]

07:33 PM on 02/07/2012

Boy you are stupid. The effective fed funds rate is 0.10%. This is for loans measured in days. The comparable US Treasury is yielding 0.08%.

http://www.bloomberg.com/markets/rates-bonds/key-rates/
http://www.bloomberg.com/markets/rates-bonds/government-bonds/us/

[Jon LoGotti]

07:04 PM on 02/09/2012

No actually he is right. The Fed funds rate flucuates on a daily basis between 0-.25%. Those banks then buy long term Treasuries which yield 2%, yields also flucuate, and make a handsome spread on safe securities instead of lending and risking that money in the economy.

[niumarmion]

07:40 PM on 02/07/2012

You are not taking into account the interest rate risk involved with this strategy. Even if the Fed keeps short-term interest rates low until 2014, an infinite number of factors could cause the world to sell longer-term treasuries wiping out the profits of the spread many times over.

[Durrrrrr]

07:48 PM on 02/07/2012

Liberals do not know the definition of maturity mismatch. The definitely have never heard of the company Metallgeschaft or what they are most famously known for in the financial world.

[Jon LoGotti]

07:09 PM on 02/09/2012

No, the profit will still be there since dealers can arbitrage cheap Fed Funds money or QE cash and buy Treasuries with them. So if the Fed Funds rate is at .25% and the 10 yr is yielding 2% then there is no risk for them and they make a nice profit from the carry trade. You didn't think that the FED wasn't lending money for banks to buy Treasuries, which are safe AAA assets and are basically the only funding currency in the interbank market without significant haircuts, where they don't have to take risks in the economy when AAA sovereign securities have 0% RWA meaning no capital has to be held against them while they rebuild their balance sheets and invest in liquid Treasuries which are risk-free and higher yielding, no matter if yields rise of they dont, espcially since the FED is manipulating the long-end of the curve by buying long-term Treasuries like the 10 yr to keep borrowing costs for C&I loans and mortgages et al for the economy. If rates rise, they will be forced into another QE, which many predict will come anyways.