The bond and equity markets cannot agree on the future of the American economy. While the major indicies set or flirt with record highs, the yield on the benchmark 10-year Treasury has fallen to a new 2014 low, returning the least interest since last June.
The yield on the generic 10-year bond dropped seven points today to 2.44 percent. The 10-year is the key Treasury for determining many market rates especially for mortgages and other longer term loans.
Equities on the other hand were at or near all time highs with the S&P 500 at a record, the Dow within 0.3 percent of its peak and the Nasdaq Composite within 3.0 percent in spite of the April tech stock sell –off.
The rout in bond yields is recent. Two weeks ago (5/12) the 10-year closed at 2.66 percent and less than two months before (4/2) the bond was paying 2.80 percent. For more than three months (1/23-5/14) the 10-year yield traded between 2.80 percent and 2.50 percent, with the majority of that period above 2.60 percent.
The beginning and end of the 15 week period (1/23-5/14) were marketed by the same 2.5680 percent low (2/3, 5/5). It was the collapse of yields through this level on May 14th that precipitated the new lower range. Since then the high has been 2.5660 on May 22nd.
Interest rates on Treasuries normally fall as the U.S. economy begins to speed up, anticipating a Federal Reserve policy shift to higher rates to forestall inflation and a potentially overheating economy.
A number of factors are joining to push rates lower despite the near universal forecast that the U.S. economy will strengthen as the year proceeds.
The general expectation that a better economy would lead to higher interest rates, particularly as the Fed had begun reducing its securities purchases in December, had led to large short positions in the bond market. Those positions became untenable as the market moved through its earlier 2014 low and liquidation of those shorts has provided much of the recent impetus.
Prices in the credit markets move in opposition to yields as a changeable rate environment is reconciled with the fixed coupon of most bonds.
Since the 'six month' comment at Janet Yellen’s first news conference in March the Fed has been at pains to insist that rates are going to remain low for the foreseeable future.
Even as unemployment moved through the Feds original goal of 6.5 percent and inflation jumped 0.5 percent in a month, the bank has dropped its specific unemployment target and has begun instead to talk about the more intangible problem of long term unemployment. Market expectation that the end of quantitate easing signals a return to a normal Fed rate policy has clearly been premature.
Secondly, though American statistics have been on the whole stronger, doubts on the potential of the economy have begun to surface, clustered around April's weak retail sales, static household income and the sharp jump in food prices.
The Fed considers core inflation, that is without food and energy changes, most important. But consumers must pay for all price increases out of a flat budget. With little or no extra income, the type of spending increases that can drive 3.0 or 4.0 percent growth are not possible.
Thirdly, foreign bond yields are also moving lower in response to weak economic growth. The German 10-year Bund sank to 1.34 percent today as unemployment unexpectedly increased in April.
Despite the German economic expansion of 0.8 percent q/q in the first three months of the year, the EU as a whole was just positive at 0.2 percent, half the prediction.
Economic grwoth in France was flat in the first quarter; Italy shrank 0.1 percent. The Italian economy has been in recession since the third quarter of 2011 with the sole exception of the fourth quarter of last year when it grew 0.1 percent.
One of the oldest market clichés is 'Don’t buck the Fed'. In the zero rate world that applies to central bank rhetoric as well as policy.
Chief Market Strategist
WorldWideMarkets Online Trading