What's Next for the Economy: Stocks vs Bonds (Marketwatch)

Bonds and stocks diverge on U.S. economy
By Nick Godt, MarketWatchLast Update: 4:20 PM ET Sep 9, 2009


NEW YORK (MarketWatch) -- For those investors who believe the stock market works perfectly at discounting risks and rewards, the U.S. economy and corporate profits must seem to be on track for a stellar recovery.

After a spectacular 50% surge since March, stocks on the S&P 500 Index ($SPX) have continued rising through the summer and into September.

Yet, the market for U.S. government bonds, considered among the safest assets around, seems to be telling a different story."There is a growing group of people following the view that we'll have a jobless recovery in the economy," said Bill O'Donnell, head of Treasury strategy at RBS Securities.

"They're asking what comes after the sugar-high from the government stimulus measures, and what they see is rising joblessness, consumers spending less and lower inflation. All in all, good conditions for bonds."

On Wednesday, U.S. stocks continued to advance after the Federal Reserve's so-called Beige Book of current economic conditions. The central bank said the economy is improving across most U.S. regions but that consumer spending remains sluggish.

The Dow Jones Industrial Average ($INDU) finished up 49 points, or 0.5%, at 9,547. The Nasdaq Composite (COMP) was up 22 points, or 1.1%, at 2,060, while the S&P 500 gained nearly 8 points, or 0.8%, to 1,033.

Separately, Treasurys turned higher after the Beige Book and after the government's auction of $20 billion worth of 10-year notes was met by ample demand.

Demand for benchmark 10-year Treasury notes surged over the past month, sending their yields (UST10Y) down by about 40 basis points. Bond yields move inversely to price.

Government bonds provide fixed income over periods of time. This means that longer-dated bonds, such as the 10-year note, are more susceptible to inflation as fixed income loses value if prices rise in general.

When bond prices rise and their yields fall, it generally means that the chance of rising inflation is waning -- along with the outlook for economic growth.

Who's right?

Unfortunately for stock investors, bonds have often provided a better gauge of economic trends than equities. A recent example was when Treasury yields began sliding in June of 2007, as defaults on subprime mortgages surged and deteriorating credit conditions led fixed-income investors to seek safety.

Yet stocks continued to rally for another four months, reaching record highs by the middle of October 2007 before taking the big plunge. In those four months, the yield of the benchmark 10-year Treasury bond had already slumped by about 70 basis points.

Perhaps similarly, yields rose sharply for most of this year, as investors abandoned the safety of bonds and jumped into the massive equity rally. But over the past few months, yields have started to slump again.

Strong demand for even shorter-dated maturities, such as the 3-year notes sold at a government bond auction on Tuesday, is now raising doubts about the economic outlook among a number of market strategists.

"What does it say about the view on economic growth that there is such big demand for the 3-year note?" asked Peter Bookvar, equity strategist at Miller Tabak, in a research brief.

"Why isn't this money going into riskier assets? Again, it's another data point of the disconnect between the U.S Treasury market and equities," he said.

The visible hand of government

"The government has got a heavy hand in this recovery," says Jack Ablin, chief investment officer at Harris Private Bank.

Ablin does believe the economy and stocks are still running on the "sugar high" provided by government spending. However, while the bond market may be looking further ahead when the economy might run out of momentum next year, he doesn't believe stocks have to come down.

"There's still 10 donuts in the box [out of 12]," Ablin says. "We've only spent about 10% of the $800 billion or so committed. "The government is still spending a lot of money and that's going to be reflected in the economy and profits at least for the next couple of quarters."

And corporate bonds also continue to improve steadily, he noted.

Meanwhile, government bonds may simply have become a good bet again because of the lack of inflation in the outlook for the economy.

With the government raising close to $2 trillion to help shore up the economy, and as markets took the view back in March that those measures had helped avoid the worst, Treasurys seemed to be a bad bet for most of the year, and yields surged along with stocks.

Some of the hesitations on the way up were that government spending would pressure the dollar and boost inflation, and that raising money might become harder as buyers of U.S. debt, including foreigners, would become more scarce.

But while the dollar has returned to its lows of the year, few believe inflation is in the cards as long as the economy continues shedding jobs, and consumer spending, which makes up for about 70% of the economy, remains muted.

And judging by the results of this year's auctions, demand for U.S. government bonds remains strong.

For Ablin, if there's one area where a weak dollar has led to too much speculation, it's commodities, including gold topping $1,000 an ounce.

"I'd think twice before melting down your Rolex," Ablin said.