Friday, October 9, 2009

Are Bonds and Stocks Telling Us We Are in a Sweet Spot?

The dollar continues to fall, reflation trades rage on for the moment, and risk assets are currently in vogue. But has anyone noticed that Treasury bonds have been rallying, too? How could it be that government bonds, which usually thrive off poor economic news and financial misery, could rally at the same time as the high-flying equity markets that benefit from economic and profit growth? Some of the technical (non-fundamental) reasons for the rally we’ve seen recently include ultra-low returns on cash causing nervous investors to seek something safe with a better yield, central banks that continue to park large reserve balances in bonds because of a lack of better alternatives, and banks that would rather buy Treasuries because they’re still reluctant to lend. Some will look at the divergence between bonds yields and stocks and conclude that one market has to be wrong - either bonds are correct and the economy is softening, which is good for bonds and bad for stocks, or stocks are correct and the economy is improving, which is good for earnings and stocks but bad for bonds.

I have a different view, which is that lower yields may be just be signaling that inflation is currently not a problem. One only has to look at the very low levels of capacity utilization, the large negative output gap (the difference between potential GDP and actual GDP), and slack in the labor markets to realize that the economy has plenty of room to grow before inflation pressures build. That has created a sweet spot for equities, allowing them to rally in unison with a cyclical rebound in economic activity without having to worry that the Federal Reserve will be pressured into prematurely tightening monetary policy. We won’t always be in this sweet spot, and at some point much higher or lower yields will probably portend either a tightening environment or very poor future economic growth, neither of which would be good news for the equity markets. But for the limited window that this goldilocks sweet spot exists, I suppose we should all try to enjoy it!