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.
Without discounting the significance of the fund-flow data, the more crucial questions are: Why are those bond-fund flows continuing? And why are institutions -- aka "the smart money" -- aggressively buying Treasuries, as are retail investors, rather than trying to sell bonds to the "dumb money" crowd? One answer is that Treasuries are being bought by those who believe the central bank soon will be doing the same thing in response to the threat of deflation. Admittedly, that is a troubling answer for stock and bondholders alike, as it suggests the Fed is meddling in financial markets rather than letting nature take its course. The history of currency interventions suggests such efforts at manipulation ultimately are doomed.
March 18 meeting -- have encouraged market participants to believe that the central bank will go to extraordinary measures to fight deflationary pressures. If the Fed really is pulling out all the stops, odds are the bank ultimately will trigger some inflation, which would be bad for Treasuries. But rather than worrying about such an outcome, fixed-income investors are "acting as though the Fed will end rate cuts and instead start purchasing long-dated Treasuries," as Anthony Crescenzi, chief bond strategist at Miller Tabak, commented on RealMoney.com. Last month, Kenneth Fisher, CEO of Woodside, Calif.-based Fisher Investments, mentioned here the possibility of the Fed buying long-dated maturities in order to inject liquidity into capital markets.
Where We BeIncreasingly, fixed-income participants believe a big buyer, namely the Fed, has emerged to help overcome potential negatives such as the dollar's decline (which resumed vs. the euro Thursday after the European Central Bank left rates unchanged), the onrushing supply of government paper, and the waning inflow of foreign capital for the three months ended February. Concerns expressed Tuesday by the Federal Open Market Committee about an "unwelcome substantial fall in inflation" -- and more explicit language about "disinflation in core prices" in minutes of the FOMC's
"When the Fed starts talking about fears of deflation, this becomes the logical outcome," Fisher said Thursday. But the money manager doesn't see much evidence of Fed buying yet, suggesting short-term rates would be markedly higher if it were occurring. The seemingly conflicting message from Treasuries and equities is largely about failed expectations, Fisher suggested: Bond yields are down because the economy hasn't been as strong as economists forecast in January. Conversely, stocks have risen because corporate earnings have been better than equity market participants feared. Notably, S&P 500 components' first-quarter earnings growth is on pace to exceed 13%, according to Thomson First Call. Nevertheless, this idea of the Fed buying long-dated Treasuries vs. shorter-dated ones -- which is legal but rare -- has recently gained widespread acceptance.
duration gap by buying long-dated Treasuries, retail investors' aforementioned ardor for bonds, and a general "flight to safety" trade amid myriad geopolitical uncertainties. These noneconomic factors help Bianco explain why we have the lowest interest rates in 40 years when, by most measures, the economy is not in its worst state in 40 years. Relative to the boom, the economy certainly feels terrible. But gross domestic product has grown for six consecutive quarters, albeit slowly, and a 6% unemployment rate is pretty low relative to American history prior to the mid-to-late 1990s. Deficits are a concern, but they've been relatively bigger in prior eras. Furthermore, while many describe deflation as "falling prices," James Grant of Grant's Interest Rate Observer offered a broader definition last year that merits reviving: "A comprehensive state of economic contraction characterized by falling prices and wages, shrinking credit, vanishing asset values, collapsing profits and declining GDP."
'Free Markets' In Name OnlyTo Jim Bianco, president of Bianco Research in Chicago, potential Fed purchases are a "noneconomic factor" pressuring Treasury yields -- even if the buying is largely being done by speculators anticipating Fed purchases. Other noneconomic factors he cited include the "mortgage convexity trade" -- notably Fannie Mae's ( FNM) apparently successful effort to reduce its
As noted above, GDP is expanding, average hourly earnings are up 3.1% in the past year, consumer credit rose at an annualized rate of 3.8% in the first quarter, and financial assets have been rallying, sharply in some cases. Among price measures, the GDP price deflator rose 2.5% in the first quarter, while the consumer price index was up 3% on a year-over-year basis in March, having seemingly bottomed in June 2002. Meanwhile, the March producer price index was up 4.2% year over year after hitting a 50-year low in May 2002. Given weakness in other inflation measures (core PPI is up only 0.9%), corporations' lack of pricing power, and Japan's downward spiral, the Fed is justified in declaring its vigilance against deflationary threats. A more foreboding explanation of low Treasury yields goes like this: The Fed helped foment an equity bubble in the late 1990s by not raising margin rates or more forcefully discouraging the notion of a "Greenspan put." After "popping" the bubble in late 1999-early 2000, the Fed subsequently lowered rates to extraordinary levels in order to fuel the housing market, thus keeping consumer spending afloat, particularly after the Sept. 11, 2001, terrorist attacks. Low rates also presumably have allowed households and corporations to repair tattered balance sheets. More recently, and with the Bush administration's tacit support, the Fed has kept rates low in order to weaken the dollar, which helps U.S. exporters and results in higher prices for imported goods, i.e. fights disinflation/deflation. Trouble is, the Fed is running out of rate-cut bullets and is now moving on to alternative measures, possibly including buying long-dated Treasuries. This may explain why Treasury yields are so low, but the Fed has a lot of balls in the air right now, simultaneously trying to "prop up" Treasuries and, indirectly, stocks, while engineering a "gradual decline" in the greenback. Even if not tomorrow or next week, the threats are that the dollar's decline will accelerate and/or inflation will re-emerge, forcing the Fed to consider raising rates. Either scenario has ominous implications for stock and bond bulls alike.