June 1, 2005
THE NEW NEW BULL MARKET IN BONDS
The yield on the benchmark 10-year Treasury Note turned more than a few heads today by dipping to under 3.9%-- the lowest since March 2004. The not-so-subtle message: the economy's cooling, and so it's safe for any and all bond bulls to come out of the closet.
By some accounts, the bond market is now pricing debt in anticipation of an outright recession. Anything less may incur a painful rebuke for buyers of Treasuries, particularly those investors who've jumped on the bandwagon at today's slim yields. David Gitlitz, chief economist at TrendMacrolytics, is among those who smell trouble ahead for the bond bulls. Bonds, he writes today in a letter to clients, "appear badly mispriced" for an economy that he thinks will grow by 3% to 3.5%, the latter being the first quarter's rate of GDP expansion.
The bond market begs to differ, of course. But are we really about to go from a 3.5% GDP growth rate to a recession or thereabout any time soon? Anything's possible, but is it probable?
Then again, bond traders can point to some supporting evidence for the sport of chasing yield. That includes today's comments from the Dallas Fed president, Richard Fisher, who advanced the central bank's penchant for transparency a notch by announcing that "we're clearly in the eighth inning of a tightening cycle," Marketwatch.com reported. ""We have the ninth inning coming up at the end of June...."
There were other goodies to chew on in fixed-income circles today. Indeed, today's release of the Institute for Supply Management (ISM) manufacturing index for May revealed that the measure dropped to 51.4 last month, the sixth monthly decline. As trends go, this one seems to have legs.
The ISM report is all the sweeter for bond bulls considering that the digital ink is still wet on last month's missive from Pimco's Paul McCulley, who wrote that "In the Greenspan era the Fed never keeps tightening once the ISM Index drops below 50." What's more, he provided the historical track record to support the observation.
A reading above 50 in the ISM gauge is said to indicate growth in the manufacturing sector; below-50 readings reflect contraction. What are we to conclude from the latest data point? Arguably, it's too close to call at this point, although finely balanced indices don't deter the bond market from jumping to conclusions these days. Nonetheless, the ISM gauge is still above 50, albeit barely. Nonetheless, growth still has the edge quantitatively speaking. On the other hand, the 51.4 reading on the ISM comes the closest to dipping below 50 since June 2003, when the metric closed at 50.4. There may be two ways to interpret this numerical see-saw, but Mr. Market today was only interested in one.
Adding to the giddiness of the fixed-income set was news that the ISM prices paid index for May declined to a 20-month low. Translated: inflation as a fear on Wall Street is as dead as Dickens' Marley. In any case, ISM reports that 16% of manufacturers said they paid lower prices in May, up from 10% in April and 5% in March. Meanwhile, a falling share of manufacturers indicated they paid higher prices: 32% in May, down from 52% in April.
Corroboration for the bond market's thesis that the Fed's rate hikes are history was also found in today's stock market action. The S&P 500 seemed to breath a sigh of relief in the wake of the ISM report by posting a healthy gain of nearly 1% today. Never mind that a slowing economy may soon come back to bite stocks; today, it was all about buying.
"The Fed has told us they will continue to raise rates at a measured pace, but each decision will be made on the basis of existing or current conditions," Hugh Johnson, chief investment officer of Johnson Illington Advisors, explained to BusinessWeek today. "And current conditions tell me that it's not a sure bet the Fed will raise rates at their June 30 meeting."
Then again, neither is it a sure bet that the Fed won't raise rates one more time. That is, unless you're measuring sentiment by watching only the bond market. For everyone else, there's the realization that getting from here to the next FOMC meeting on June 30 exposes investors to the risks of fresh economic news. Among the potential gremlins that could crash the current party unfolding in the bond market: the import price index, scheduled for release on June 10; and the producer price index, which will be updated anew on the 14th of this month. And as recent history shows, these measures have shown a tendency to rise. Will history repeat itself? For the moment, though, such releases, and the risks they may or may not represent, are a world away.
Nonetheless, the enlightened investor should keep in mind that these are strange times. Exhibit A is the suspicion that money is probably flowing out of the euro and into the dollar in heavy doses in recent days for reasons that have less to do with finance and more with politics. In the wake of France's rejection of the European constitution on Sunday (and Holland's "no" vote today), it's suddenly chic to sell Europe and buy America again, and that may be no small driver in today's Treasury rally. The dollar certainly continues to exploit the euro's new ills. The U.S. Dollar Index closed above 88 today for the first time since last October. It's hard to know where the new migration into the dollar is ending up, but it's a safe bet that some, if not most is being parked (temporarily?) in Treasuries until the euro bashing subsides a bit.
Yes, perhaps the shift into the greenback marks a turning point of some import that will prove enduring. Or perhaps not. But politics and finance can make for strange and volatile bedfellows, which is why the ancient gods of finance preached diversification in both bull and bear markets.
Posted by jp at June 1, 2005 7:35 PM
Brilliant commentary. I think you are correct on every front out there. It is certainly true that cash has been flowing out of the euro, qualifying the recent euro selling more as liquidation than speculative flows or natural flow shifts. This will continue to put huge pressure on the currency. I also agree with the comment referring to the stock market. It seems to me that theoretically the bond market -could- be correct, but if that is true then the stock market will get hammered one of these days. With oil at near $55/bl again, I wouldn't be shocked to see a near term correction in stocks.
The only question in my mind is how much have recent events threatened the stability of the EU? If one could determine that he would have the keys to investing for the next bit.
Posted by: Bill Konrad at June 2, 2005 12:35 PM