Minyan Mailbag: What are bonds saying?
Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.
Can one of the Professors please attempt to explain what bonds are telling us? It looks as if someone short is getting killed or they are screaming deflation, ergo recession, or maybe a combo meal of both? All I know is, unless we are in bizarro world, last time I checked, stocks don't go up during a recession...something has to give.
Perfectly consistent with decreased time preferences - i.e. deflation and risk reduction economy-wide. Riskier assets are being sold and the liquidity that is left is flowing into bonds (perceived safety). The yield curve has been flattening since August 2003 (22 months now) and the spread between 2/10s is down from 274 bps (then) to 44 bps now. My models have spreads tightening further and possibly inverting this fall. There is the real potential for a short-term reversal in bonds for a week or two but the longer term trend remains down now. So far the Japanese analog is holding well: in deflationary periods EVERYTHING goes down but Treasuries. Forget stagflation; the commodity complex is screaming deflation (copper, lumber, etc.). And the yield curve is echoing the same.
They do before the recession is in force as the Fed pumps liquidity into the system to try to avoid it in the first place. Stocks are trading purely on liquidity as there is little alternative for other investment. This is how the Fed gets investors to increase risk, a risk they really can't afford to take.
Bonds are in a world of monetization: the Fed flattening the yield curve to protect asset prices and debt. For example, the mortgage debt guaranteed by Fannie (FNM) and Fredddie Mac (FRE) alone is over $3 trillion, 40% of the total national debt of $8 trillion (excluding off-balance sheet debt). Without the GSEs buying mortgages from originating banks, the liquidity that the Fed is producing would not fully make its way into the system. In other words, the real estate market is the vehicle by which this liquidity makes its way into the hands of consumers; otherwise it would stop at banks and not be lent out.
The game continues as imbalances build and build. Bonds are not really telling us anything, the Fed is: we will do whatever is necessary to provide liquidity, including monetization.
Something will give when the market says enough!
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