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Thursday, August 5, 2010

Bond Market and Yield Spread Update

Back in March, I wrote this post: What the Bond Market is Trying to Tell the Stock Market: A Look at the Yield Curve and Expectations.

Here is what I had to say then:

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:

Here was my chart from that time

Since then we have had what I believe to be the top in the equity markets. The yield curve did a little flattening, but it is still quite steep by historic standards. And recently, it has begun to widen again (short end of the curve keeps compressing but the long end is drifting higher). And as I predicted and pointed out back in March, this is bearish for equities, and so far that has proven true. And I think that trend is quite likely to continue.

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