Blame It On the Bonds?

Daily State of the Markets 
Monday Morning – August 16, 2010  

For much of Friday’s session, stocks held up pretty well. Up until approximately 2:15 pm eastern, it felt like the market had stabilized after a rather volatile week of worrying about the state of the economy. But, just about the time you may have been tempted to think that the worries were overblown, the yield on the 10-year took a dive, closing at the low of the day. And just like that, traders once again began to worry that they might be missing something.

Recall that earlier in the week, the worry among stock traders was that the Fed might know something that they didn’t. After all, there were those that viewed the Fed’s move to start buying treasuries again as a sign of panic. So, with the bond market now within 0.003% of its lowest level since late March 2009, stock traders (and/or their computers) decided to sell first and ask questions later.

Speaking of questions, the big one right now is what the dive in the bond market really means. Conventional wisdom says that the bond market sees severe economic weakness ahead. Then there are those that view the out-and-out collapse of bond yields as an indication that the economy may be in the throes of a Japanese-style deflationary cycle. In sum, this group argues that the stock market has yet to wake up and smell the macroeconomic trouble brewing.

However, there are those, PIMCO among them, that aren’t buying the doom-and-gloom scenario and suggest that “structural” issues in the bond market may also be to blame. Exhibit A in this argument is the action of high yield bonds. You see, if holders of junk bonds were starting to sniff out economic trouble ahead, high yields would be in trouble as the bonds trade largely on expectations of default. But, take a look at the iShares High Yield Bond ETF (HYG) on a weekly chart basis. Sure, junk didn’t have a great week. But given that the HYG is just a couple percent below its recent high, there doesn’t appear to rampant fear of an economic calamity here.

Exhibit B in the argument that there is more than meets the eye in terms of the recent dive in bond yields is the public’s obsession with government bonds. According to Barron’s, total net inflows into bond funds since the start of 2009 has exceeded $500 billion. And Bloomberg reports that PIMCO, the manager of the biggest bond funds on the planet, has been taking in more than $1 billion a week. Yet, the bond kings have actually been reducing their exposure to government bonds lately. Thus, it is hard to understand why the smartest guys in the room, who also just happen to be taking in money hand-over-fist, would be selling government bonds if the economy was heading for recession.

So, while the bond market’s decline was clearly the cause for stocks closing on the lows Friday afternoon, we can’t jump on the “the world is ending and the stock market just doesn’t see it yet” bandwagon. But, we will promise to keep a close eye out on the data in the near future – just in case.

Turning to this morning… Japan’s GDP data is proving problematic this morning as the +0.4% gain year-over-year was well below consensus for +2.3% and is raising recessionary fears again. This is evidenced by yet another drop in bond yields.

On the economic front… The Empire Manufacturing Index (designed to indicate the state of the manufacturing sector in the New York region) for August rose to 7.1, which was slightly below the consensus expectations for a reading of 7.70 but above the July reading of 5.08. The good news is the Employment Component of the report came in at 14.29, which was above July’s reading of 7.94.

Finally, don’t let success go to your head or defeat into your heart…

Pre-Game Indicators

Here are the important indicators we review each morning before the opening bell…

• Major Foreign Markets:
  • Australia: -0.35%
  • Shanghai: +2.11%
  • Hong Kong: +0.19%
  • Japan: -0.61%
  • France: -0.91%
  • Germany: -0.37%
  • London: -0.42%

   

• Crude Oil Futures: + $0.05 to $75.45
• Gold: + $11.20 to $1227.80
• Dollar: higher against Yen, lower vs. Euro and Pound
• 10-Year Bond Yield: Currently trading lower at 2.618%

   

• Stocks Futures Ahead of Open in U.S. (relative to fair value): 
  • S&P 500: -2.65
  • Dow Jones Industrial Average: -22
  • NASDAQ Composite: -4.70  

Wall Street Research Summary

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