Should we be worried that the US bond market has defied all the sceptics and has turned out to be the stellar performer of the year?
Yes, if you believe Gluskin Sheff chief economist, David Rosenberg.
In his latest article, Rosenberg points out that at the beginning of the year, virtually no one believed that the prices of US treasuries would rise, forcing bond yields to record lows.
At that time, most economists were confident that the US economic recovery was on track, and that the US Federal Reserve was poised to start shrinking its bloated balance sheet by selling off some of its holdings of US treasuries and mortgage-backed securities. There were also fears that massive US government deficits would push the yields on US government debt sharply higher.
Instead, bond yields have fallen sharply, as a slew of disappointing economic data has fuelled fears that the US is about to fall into a treacherous period of deflation. After Friday’s dismal unemployment figures were released, the yield on two-year Treasury notes fell to a record low of 0.5%, while yields on 10-year bonds fell to a 15-month low of 2.82%. The market is now expecting the US Federal Reserve will keep interest rates at close to zero for at least another year, and there is speculation that the central bank could be about to embark on a new $US2 trillion quantitative easing program to bolster the faltering economy.
But Rosenberg – who was one of the first economists to warn of the deflationary risks for the US economy – says the sharp fall in bond yields in recent months contains a bleak warning, both for the economic outlook and for equity markets. As he notes, the yield on 10-year US treasuries has plunged by almost 120 basis points since its peak of 4.01% in early April this year.
“Declines of this magnitude very often presage the onset of bear markets and recessions. Typically, equities and then economists are late to the game. Nothing we are seeing is any different from the past, at least on this score. What is key to note is that the bond market is the tail that wags the stock market’s dog – it leads.”
Rosenberg points to other instances where the bond market has correctly predicted that the economy was about to slow sharply – before share market investors realised what was happening.
“The 10-year note yield peaked on May 2, 1990 at 9.09%. By December 12, 1990, the yield was all the way down to 7.91%. The S&P 500 peaked on July 16, 1990, the same month the recession started. So Mr Bond led both by over two months – the 120 basis point slide in yields by December provided ratification.” Even then, Rosenberg notes, there were still some, including the then head of the US Federal Reserve, Alan Greenspan, who believed at the time that a recession had been averted.
Almost a decade later, the bond market again demonstrated that it was better able to predict economic contractions than the share market.
“The yield on the 10-year T-note peaked at 6.79% on January 20, 2000 – the stock market peaked less than eight months later on September 1. By November 28, 2000, the yield had plunged to 5.59% – down 120 basis points (as is the case today), again providing ratification that we were not heading into some routine soft patch. Indeed, the recession started in March 2001, so the bond market again played the role of the real leading economic indicator, not the stock market.”
More recently, Rosenberg notes that the bond market was flashing a warning signal in the lead-up to the global financial crisis.
“In the most recent cycle, the 10-year T-note yield reached its high on June 12, 2007 at 5.26% – by November 21, it was all the way down to 4.00%. The S&P 500 peaked on October 9, 2007, three months after the peak in the bond yield. Yet again, a 120 basis point slide was the smoking gun for the economic downturn.”
But Rosenberg isn’t entirely happy that the market has come around to his way of thinking, and has priced it into bond yields.
“As contrarians, we much preferred it when the crowd was still crowing about inflation and there was dearth of deflation talk….We are not yet prepared to abandon our long-standing deflation views but we are nervous that this is now becoming a mainstream forecast.”
Still, he takes some solace in the fact that most economists are still cheerfully dismissing the likelihood that the US economy will endure a “double dip” recession.
This article first appeared on Business Spectator.
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