THE BLOG
07/02/2009 05:12 am ET Updated May 25, 2011

The Trouble with Markets

In recent months, the spread between short and long-term bond yields has increased significantly, hitting record extremes. Many market-watchers believe the widening differential reflects two concerns.

The first centers on whether the market can absorb the tsunami of government bond sales needed to fund the various bailouts and stimulus measures Washington has agreed to, as well as the budget gaps that have opened up as the economy has weakened.

There is also a growing fear that the recent jump in government borrowing and the Federal Reserve's efforts to boost liquidity through "quantitative easing" -- that is, by cranking up the monetary printing presses -- will trigger a bout of inflation that slashes the future value of the money that will be used to pay off these obligations.

But not everybody agrees with this assessment. According to a recent Reuters report, Federal Reserve officials are "puzzled" by the steepening yield curve. While they accept that investor worries over inflation could be behind the recent moves, they also allow for other explanations.

One possibility, Reuters writes, is that the steepening yield curve -- along with an overall increase in bond yields -- suggests "an economic recovery is more certain, meaning less need for safe haven government bonds and a healthy demand for credit."

Alternatively, some central bankers believe it could be a technical development, reflecting a decision by China, "the largest foreign holder of U.S. Treasury debt,... to refocus its portfolio by leaning more heavily on shorter-term maturities."

With all of that in mind, it's probably fair to say that the message of this particular market is somewhat muddled, and that the moves seen so far could point to any number of outcomes, leaving observers in the dark as to just what the future holds.

But this is not the only example of markets sending a mixed -- or even a misleading -- signal. Recent trading in the shares of General Motors represents another case in point.

Last Thursday, the Wall Street Journal reported that GM's bondholders "soundly rejected a debt-swap offer critical to the auto maker's survival, pushing the company closer to a bankruptcy filing that could come in the next few days." The shares fell on the news, though, oddly, not by much. They closed at $1.12, down three cents.

A story in Friday's Journal , "GM in Last Lap to Chapter 11," was even more specific about the company's ominous near-term prospects, noting that a filing was planned for Monday and that current GM shareholders would end up with nothing. Not suprisingly, the shares came under further pressure, dropping by a third to $0.75. Not quite zero, but bolstered, perhaps, by hopes of a weekend miracle.

Monday's action, however, was something else, reflecting what appears to be a major disconnect between markets and reality. Before trading even began, news reports and remarks by lawyers, policymakers, and bankers made it clear that the 100-year-old car manufacturer was heading to bankruptcy court.

Given that the company's liabilities are far in excess of its assets, that meant shareholders would almost certainly end up with nothing, nada, zilch once it was all over. And yet...by the time trading ended at 4 o'clock, the shares were unchanged on the day. Strange, indeed.

The point, of course, is that what takes place in markets doesn't always make a whole lot of sense, nor does it necessarily serve as a guidepost to what may (or may not) happen in future.

In fact, that notion was no more evident than when share prices were powering to all-time highs in October 2007 -- amid all sorts of evidence that the financial world was in serious trouble, and just two months before the start of one of the worst downturns this century.

With that in mind, some might wonder what the recent near-40 percent rally in the S&P 500 index -- which the bulls blindly cheer as a leading indicator of good times to come -- is really telling us.