The Bond Market's Hidden Agenda

Thursday's setback notwithstanding, the equity market has been rambling along as if robust economic growth is imminent. However, the Treasury market seems to be saying the optimists are dead wrong.

Gains in corporate and high-yield bonds seem to support the equity market's latest bout of optimism. But if fixed-income participants foresaw economic growth, especially the strong variety, it's almost unfathomable that yields on the benchmark 10-year note -- which move in the opposite direction of its price -- would be at 3.67%, or just 12 basis points above multidecade lows. Faster growth is poison to Treasury investors because it historically has been accompanied by inflation, which undermines the value of future interest payments.

Assuming the signals from stocks and Treasuries are truly contradictory, figuring out which are right is crucial to determining the financial markets' next move. What may be happening, however, is less about two opposing views on a recovery than about reactions to two perceived events. Stocks are anticipating economic improvement, while bonds, which are more skeptical of a recovery, also are focusing on an anticipated anti-deflationary intervention by the Federal Reserve.

"Treasury market investors don't believe we've got any recovery on our hands, but equity investors are hoping this [economy] is going to turn around, and are anticipating it," said Donald Straszheim, president of Straszheim Global Advisors in Santa Monica, Calif. "The divergence is pretty striking and I can't remember a time in which it's been this stark."

After previewing this topic Wednesday, one source suggested the Treasury market's robustness is due largely to demographics. Baby boomers, wary of equities and focusing more intently on retirement, are increasingly favoring bonds, a notion that mutual fund data support.

Bond funds had inflows of $43.5 billion in the first quarter after taking in a record $140.5 billion in 2002, according to the Investment Company Institute. Following outflows of $27 billion last year, the first full year of outflows since 1988, equity funds sustained additional outflows of nearly $11 billion in the first quarter, according to ICI.