There’s been a party going on in bonds: Prices have been rising, pushing yields lower. Traders have been buying Treasuries on good news … bad news … any news. What gives?
My view: Fixed income investors are rushing to Treasury bonds as a safe haven. After all, evidence of economic weakness has been pouring in. The economy decelerated this summer, and lately, it’s been looking even weaker. Here’s just a sampling of the recent evidence:
- The Institute for Supply Management (ISM) manufacturing index dropped to 52.9 in September from 54.5 a month earlier. That’s the lowest in 16 months.
- The ISM’s service sector index did even worse — it fell more than four points to its lowest level since April 2003.
- Personal spending gained a meager 0.1% in August. That was down from a 0.8% rise in July, and the smallest increase since November 2005.
- Durable goods orders tanked 0.5% in August, after falling 2.7% in July.
- Employment firm Challenger, Gray & Christmas said job cut announcements skyrocketed 40% year-over-year in September.
In short, we’re seeing fears of a slowing economy trump inflation concerns. This is why bond investors are currently willing to accept lower yields. And that’s why they’ve even been willing to accept lower yields on money locked up for 30 years than money committed for only a few months.
Sound upside down? It is. There’s even a term for it – the “ inverted yield curve.†(Editor’s note: For more on the yield curve, read Mike’s story, “The Big Bond Squeezeâ€). The main thing you need to know is that by watching bond buyers, you can get a feel for where they think the economy is headed next.
Bottom line: Bond investors are hoping – even expecting – that the Federal Reserve is going to CUT interest rates very soon.
The Fed Itself Is Singing
A Different Tune
Meanwhile, the Fed is saying loud and clear that a cut won’t come tomorrow … or next week … or later this month, when the Fed meets next. In fact, it won’t be anytime in the foreseeable future.
Indeed, Fed officials – as well as central bankers in Europe – are on a completely different page than the bond market. They don’t seem concerned about economic weakness. Just this week …
Fed Chairman Ben Bernanke acknowledged in a Washington Q&A session that housing was seeing a “substantial correction.†He said that the slowdown could cut economic growth by about a percentage point in the second half of this year.
But, in virtually the same breath, he said, “To this point, other parts of the economy are remaining relatively strong.â€
Translation: “We see no reason for a rate cut right away, if at all.â€
Fed Vice Chairman Donald Kohn then came out and warned the bond market in stark terms: “Don’t sell the Fed’s concern about inflation short.â€
He added: “To date there is little evidence that this correction in the housing market has had any significant adverse spillover effects on the other parts of the economy.â€
In other words, Kohn doesn’t think the recent softness in the economic data justifies a rate cut, either.
European Central Bank President Jean-Claude Trichet pushed through his fifth interest rate hike since December.
He said inflation risks “remain clearly on the upside,†and added that economic growth should remain robust, wage demands could push up inflation, and that ample liquidity and money supply growth were troublesome.
So, the pressure’s still on in Europe, too.
When the Fed and the bond market go to war, you don’t want to get caught in the middle. Here’s the question investors need to ask themselves:
Is Now the Time to Chase
High-flying Bonds and Stocks?
The speed and magnitude of the recent rally in bonds makes me nervous. So does the Dow’s recent sprint to new highs.
Reason: It looks like we’re getting BOTH a weaker economy PLUS the fuel for more inflation – a lot of excess money sloshing around out there. For example, we’re still seeing strong growth in non-mortgage lending throughout the banking sector. And bond buyers are still pouring money into higher-risk bonds.
Fed rate hikes are supposed to drain money out of the economy, but so far they haven’t succeeded, and the Fed knows it. That’s why they’re trying to warn investors not to go too far too fast.
I’d listen to them and be careful here. Consider keeping your fixed-income money in short-term Treasuries – anything with a maturity of two years or less.
As for stocks? I think there are some opportunities in select food shares, lower-risk banks, foreign stocks, and a handful of other areas. In fact, Martin and I have been recommending many of these investments to our Safe Money Report subscribers.
But I wouldn’t go hog wild chasing this Dow rally. With complacency high and tension building behind the scenes, I think there’s a rising chance that we’ll see a sharp, out-of-the-blue “surprise†pullback.
Until next time,
Mike
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