Five Things You Need to Know: The Newest Conundrum

Kevin Depew's Five Things You Need to Know to stay ahead of the pack on Wall Street:

The Newest Conundrum

In July 2005 then-Federal Reserve Chairman Alan Greenspan coined the term "conundrum" to describe the fact that, despite 15 consecutive interest rate hikes, bond yields at that time remained unusually low.

In retrospect, that word remains one of the very few things that Greenspan can be said to have truly "coined" during his tenure as chairman. So it's somewhat ironic that today a new conundrum exists: the not just unusually low yields, but extremely low yields on government bonds; yields so low that for the first time since the 1950s the dividend yield on the S&P 500 at 3.3% exceeds the yield on the 30-Year Treasury.

Of course, the knee-jerk reaction is that bonds must be in a massive bubble and/or stocks must be drastically underpriced. For many, that view is a beyond question. But wait, there's more. Among other foregone conclusions making the rounds these days are the following:

• A sharp rise in inflation is imminent
• Bonds are offering, in the words of Jim Grant, "return-free risk" as the longer-term economic prospects of the United States come into doubt
• Nominal yields are sure to be much higher five years from now

Well, I'm not a fan of foregone conclusions, especially when they seem so intuitively obvious. It does seem obvious that the reflation efforts of global central banks will result in massive inflation. It does seem obvious that nominal yields in several years will be much higher. And it does seem intuitively obvious that a country, such as the United States, that will issue several trillion dollar in bonds this year will not be able to attract investors without either a) sharply improving economic prospects, or b) vastly higher nominal interest rates.

What Are We Missing?

So what is everyone missing? Simple: a structural deflationary debt unwind compounded by a lack of savings and a glut of production and inventory. There are no quick, easy re-flationary answers to this cocktail of excess.

Only time will resolve these imbalances and, as was the case with Japan's structural deflation, as the recovery unfolds bond yields will remain at unimaginably low levels.

The Economist magazine brought up the "template of Japan" in an article this week, "Yielding to none: The dilemma facing investors in government bonds":

"Many people thought Japanese bonds were overpriced when yields fell to 1-2% in the late 1990s. They have stayed around that level for the past decade, despite a vast amount of issuance (at $8.7 trillion, according to Bloomberg, the Japanese government-bond market is the biggest in the world). Even the expected $2 trillion of American issuance this year will leave its debt well below Japan’s."

Of course, as The Economist points out, a crucial difference is that Japan, running current-account surpluses, owed the money to themselves; America owes the money to foreigners.

TIPS "Irresistible"

As if to underscore the fact that virtually everyone appears fully on board with the Treasury Bubble/Massive Inflation meme is a Bloomberg piece this morning on U.S. Treasury Inflation-Protected Securities, or TIPS. Yields TIPS indicate almost no rise in consumer prices for the next decade, a move largely consistent with the Japanese deflationary template.