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What the Bond Market is Trying to Tell the Stock Market: A Look at the Yield Curve and Expectations

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March 19, 2010 – Comments (0)

A lot of people have their pet theories on what a steepening yield curve means for both economic growth and the response by the stock market. I am no different, I too have my own pet theories. So lets dive in.

Let first talk about the current market on US Sovereign Debt ... The Yield Curve is STEEP.

Here is a current look at the Treasury market From Bloomberg:

ENLARGE

What Does a Steepening Yield Curve Mean?

This is not a simple "if the yield curve says this, then it means that". Anybody who refutes this statement is blowing hot air. There are a lot of factors that affect the yield curve behavior, they all work together and none of them are completely independent. Here are a few:

1. Inflation expectations
2. Debt Supply
3. Investor confidence especially by Foreign Governments
4. Artificial signals / curve manipulation

In this environment it pays to keep one aspect front and center that puts the rest of these factors into perspective: THE US GOVERNMENT IS RUNNING *MASSIVE* DEFICITS. The amount of supply is saturated. Budget control and fiscal restraint is out the window. So in this environment, the government is running the biggest deficit that the market will let it get away with.

What this does is that is biases the interpretation (in my opinion at least) in the realm of increased inflation expectations. This is why the long end of the curve is so high. The government is planning on solving the problem with more debt. This is no secret. This is the published game plan.

But there is another aspect that is much more interesting:

Since mid 2008 the short end of the yield curve went effectively to zero ... and it has stayed there ever since. Even after this "magic" recovery in the economy and the stock market, the short end of the yield curve stayed low.

Now why would that be?

Is the Treasury tightening the supply of debt? Nope. Like I said above, the government is issuing as much debt in all times frames, as much as it can get away with.

So why isn't the yield curve flattening they way it normally does in a recovery.

Because foreign Governments and large bond investors have been routinely buying the short end of the curve and dumping long term debt for short term debt. The US Economy is in a period of high unemployment and declining tax revenues, and spending is increasing not decreasing, and deficit spending is expected to be a bigger problem in the future, not a smaller one. The bond market is looking at this "recovery" very skeptically and keeping its money is short term assets, which are short term T-Bills/Notes. Essentially the bond market is staying in cash.

This should be most troubling to equity bulls who are fundamentally engaged in the recovery story. (Many have been bullish since March 2009 from a long "trade" perspective. Those bulls have made a killing and a very good call. I am not talking about them. I am talking about the Long Term Buy and Hold types)

So What Does This Mean for the Yield Curve Going Forward?

I think it is going to continue to steepen. I think there will be continue to be strong demand at the short end of the curve and I think the long end of the curve has higher to go.

And no, this is not bullish for equities:

ENLARGE

Gary at biiwii has been talking about many of these issues for years, informing and educating. And he has been noticing some ominous patterns take shape on the yield history for many government debt symbols on the long end of the yield curve for the past several months.

Take a look at the possible inverted head and shoulders on the 30 year yield from his post: Inflation

ENLARGE

Things will start unravelling in a hurry if this pattern comes to fruition.

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