Something very odd appears to be happening on Wall Street this month. For each of the past six weeks, the stockmarket has risen, a sign - or so one would think - that investors think the "soft patch" of the summer is behind us and the path ahead for the American economy is a smooth one. Yet at the same time, yields on ten-year US government bonds have fallen - from around 4.8% in June to 4% this week. When the economy is "running hot", you'd expect stocks to rise and bonds to fall as investors switch into higher-growth equity markets. However, when the economy is simply "sputtering along", you would expect the prices of bonds to rise in expectation of rising interest rates, and those of shares to fall. Today, they're both rising: the markets, says Daniel Gross at https://www.slate.com/, are "about as polarised as the American electorate".
That has left many market participants very confused - from the press to the brokers. Last week, Morgan Stanley reported a 34% drop in its third-quarter earnings, largely because the bank's traders had bet that bond yields would follow interest rates upwards. That's exactly what should have happened, given the stage of the economic cycle we are supposed to be at. Ever since ten-year Treasury yields reached their nadir at about 3.1% in summer 2003, all the talk has been about a growing economy, firming inflation, and, since June, rising interest rates. So, by early summer, bonds had slumped and yields were above 4.8%. As The Economist points out, that "should have brought a warm glow of satisfaction" to those who earlier in the year had suggested that ten-year Treasuries would sport yields of 6% by the end of the year. Not any more.
The Big Question
This odd move poses the biggest financial-market question in the world right now. What is the bond market telling us? Is the fall in yields just a trading rally in a bond bear market, or is the bond market telling us something significant about the outlook for the US economy?
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There is a possibility that the bond-market move is reflecting not fundamentals, but just increased foreign buying of Treasuries. The FT points out, for example, that the rising oil price has left the oil-producing nations with cash coming out of their ears. They could be recycling a large percentage of this into the US bond market, pushing prices up and yields down. The Asian central banks are also still enthusiastic buyers of bonds (they seem to be "impervious to value considerations when pushing their foreign exchange reserves into US bonds", says Phillip Coggan in the FT). In July and August the Bank of Japan pumped some $15bn into Treasuries. And there may be a few more months of buying to come: at the end of August the Bank of Japan still had $122bn in cash, according to The Economist.
This buying could in turn have triggered short-covering by the hedge funds and traders (forcing them to buy back bonds they had short positions in - explained on page 34). Short covering can cause sharp, but usually short, jumps in the markets. This could just mean that the bond rally of the last four months is, as Christopher Wood of CLSA puts it, just "a giant fake out" driven by Asian central-bank buying.
Something evil this way comes
Is the bond market signalling something else entirely - that this economic cycle is past its peak already? The economy expanded at a mere 2.8% annualised rate in the second quarter and many US economists have ratcheted down their forecasts for the second half of this year. Bond investors may well think that the best growth is already behind us: they're betting GDP will continue to disappoint. And they are probably right. The encouraging strength of GDP growth earlier this year was very much a function of massive public-sector impetus. And I'm far from convinced that the growth will be sustainable once the policy stimulus of tax cuts and high government spending is removed.
Indeed, US firms' profit forecasts for the third quarter are already beginning to fall short of analysts' estimates. A rash of earnings warnings with the large consumer-orientated companies is particularly disappointing. Moreover, this suggests that the recovery is very fragile. With interest rates still at extraordinarily low levels (the federal funds rate is still only 1.75%), you would assume that the economy wouldbe going great guns. As Merrill Lynch's David Bowers observes: "What kind of economy loses momentum before short-term rates have barely even got to 2%?"
The jobless recovery: still jobless
Much of this fragility is still a hangover from the technology bubble of the 1990s, which spawned massive overinvestment and left America with a high level of excess capacity. The result is that one of the main legs of normal self-sustaining economic recovery, capital expenditure, has been, and will remain, weak in this cycle. Of far wider concern then is the jobless nature of this upturn. If the economy can't generate enough jobs, consumption will falter and the recovery will stall. Since the US consumer accounts for a quarter of total global demand, that's bad news. CLSA's Christopher Wood notes "total nonfarm payrolls are still one million, or 0.8% below the level reached in March 2001. This is the first time since 1939 that employment has still not yet fully recovered 41 months after the previous business cycle peaked." Take away the effect of tax cuts and fears are that next year the economy won't be able to stand unaided.
And deflation never went away
A year ago, the market's big bugbear was deflation. Many were convinced that in the wake of the collapse of the tech bubble, the US potentially faced the same sort of long, slow deflationary recession that has plagued Japan since it's own bubble ended in 1990 -what Bill Bonner calls "the Soft Depression" and Albert Edwards at DrKW has dubbed "the New Ice Age". By the beginning of this year, the worry had changed. With commodity prices and oil rising fast, commentators focused on inflation. Crude oil averaged less than $20 a barrel in the 1990s; so far this decade, the average is closer to $30 a barrel, and this week it hit $50. John Browne, chief executive of BP Plc, reckons it's "unlikely that we will see the weak prices of the 1990s ever again". This scares US Fed governor Edward Gramlich, who is all for promoting growth, but fears "the worst outcome is for monetary policy makers to let inflation come loose from its moorings".
Raising rates just to cut them
But what if the deflationary dragon has not been slain? An increasing number of analysts - Bonner and Edwards still included - hold that inflationary pressures have peaked already. As Christopher Wood points out, "With the core CPI inflation, excluding food and energy, falling from 1.9% year on year in June to 1.7% year on year in August, there is growing evidence that inflationary pressures have peakedfor this cycle". This rather suggests that the Fed is only raising interest rates this year at all in order to have some scope to cut them when the economy needs serious stimulus again. You can't cut rates much if they're already at record low levels.
Who's right?
So just who is right? The optimistic stockmarket investors, or the pessimistic bondmarket investors? The jury is still out, but I would be inclined to back the bondmarket investors. This has never been a normal recovery and it doesn't take a genius to see that it has been driven more by the public than by the private sector (As Warren Buffett once said, "Give me a trillion dollars and I'll show you a good time too"). What's more, while the current situation is odd, there are precedents. The first, as the FT's Lex column points out, was in 1971. Then, too, Treasury yields fell while rates were hiked and "the Fed was soon cutting interest rates again". The second is Japan. And if the US follows its example, there could be a very nasty decade ahead - for equity investors at least.
