Bonds markets are telling investors that a prolonged period of low rates will be necessary to dig out from the deepest recession in almost a century.
In the United States short rates are effectively zero. The American 10 year bond closed at 3.32% on Friday, a minimal ask considering the record amounts of debt issued and to be issued by the Federal Government. Bond investors have not demanded a premium return for taking on ever greater amounts of debt. The flood tide of government debentures has not driven bond prices into the depths.
But equity prices are even more buoyant. They predict a strong, almost immediate economic recovery. The MSCI world index of global equity prices is nearly 24% higher this year, an amount equal to its first quarter drop. The index at the epicenter of the financial crisis, the Dow, is 47.6% above its March 9th low; though still 32% below its October 2007 record of 14,164.53. Similar advances can be found in almost all the first world's equity markets. Emerging markets have performed even better, up more than 60% since the beginning of the year; they are now more than 90% above the bottom. The Korean Kopsi, the Indian Sensex 30 and Brazil's Bovespa have become the new darlings of active investment.
But which prediction will come true? The strong economic growth anticipated by the equities leading to inflation, higher interest rates and chastened fixed income investors? Or the weak and slow recovery predicted by the bond market with consumers unwilling to spend, high unemployment and moribund business investment?
But perhaps this is the wrong opposition? Is there any factor that could be driving both stock and bond prices higher regardless of economic circumstances? The answer is liquidity or cheap money; the emergency creation of the world's central bankers.
But before we examine the effects of this tidal wave of cash, let's see if last week's American statistics support one economic case or the other.
They do not. The most recent spending and housing numbers are not indicative of a strong recovery or an economy slipping back toward recession, (my assumption is that economic growth in the third quarter will be positive).
Durable Goods Orders, items meant to last several years, fell 2.4% in August much worse than the predicted 0.4% gain. It was the weakest reading since January. The headline number includes sales from the volatile commercial airplane sector and Boeing Company added 32 orders in the month as opposed to the 44 in July. But the ex-transport number, that is without airplane orders, was flat and well under the +1.0% predicted by economists.
Outstanding consumer credit, reported prior to last week, declined a record $21.6 billon in July. It was the tenth negative month in the last twelve and the sixth in a row. Restrained consumer spending and a near record low capacity utilization of 69.6% in August (the lowest was 68.3% in July) will probably keep companies from investing in new plant and equipment, hiring employees or returning some capacity to production in the fourth quarter.
Auto makers may also have a difficult quarter with demand having been drained forward by the government's cash rebate program. Edmunds.com reported sales forecasts running at a 9.3 million annual units in September. For comparison in September 2008, in the middle of the financial meltdown, units were running at 12.5 million per annum
Homes sales have improved but the small increase in prices is not nearly enough to augment consumer spending. With so much equity having been lost there is no equity to withdraw for supplemental income. New homes sold in August at a 429,000 annual pace. That is 100,000 units better than the low in January of 329,9000 but it is far from the 10 years average of 916,840 million units and light years from the peak of the housing boom in July 2005 when 1,389,000 homes changed hands.
Existing home sales have jumped 13.6% from the January low of 4,490,000 to 5,100,000 in August. But as with new homes, this is below the 10 years average of 5.78 million and you have to go back to January of 2001 to find such a low number pre-crash.
With American unemployment and underemployment rising, the housing market stagnant, and consumers engaged in serious deleveraging, it is hard to see where the consumption will come from to support a strong economic recovery. Some of the best equity performers are stocks with a large percentage of their earning from overseas operations. These firms have a double benefit, faster foreign GDP growth and the trading boost of a weaker dollar when profits are repatriated.
The case for a strong economic recovery is unproven. A substantial amount of third quarter economic activity was due to various government stimuli--the now ended cash for clunkers rebate and the $8,000 real estate purchase credit scheduled to expire at the end of November. Inventory replacement also played a part and the natural bounce after such a hard economic fall. But with the exception of the real estate credit which may be extended these stimuli will not be repeated in the fourth quarter. Sustained economic growth needs consumer participation which is simply not at hand.
History is unfortunately a poor guide to our choice of economic futures as well. In general the steeper the economic collapse the stronger the subsequent economic growth spurt. But it is also well documented that recoveries from financial recessions are slower, weaker and more prone to relapse than normal business cycle recessions. And this has been the most serious financial recession since the 1930s.
But there is a more pertinent explanation for the rise in bond and stock prices since March
Stocks and bonds are both having a grand liquidity rally. With interest rates exceptionally low and the economy flooded with cash, there is no place to earn return. Money mangers are judged by their monthly, quarterly and yearly returns. They have no choice but to get on board the rallies. Their economic view is irrelevant; it is unimportant whether fundamental developments justify a rally. A manager's performance is judged against the market and the market is up
There is a similar situation in the bond markets. If bond traders were disposed to take the stock rally as an indicator then their response would likely be to sell bonds anticipating higher rates in the near future. In normal times prices in equities and bonds tend to move in opposite directions.
But the normal progression of rising equities presaging a stronger economy, inflation, lower bond prices and higher rates has been broken by the Fed insistence that rates will stay low for a long time. To paraphrase Ulysses S. Grant, 'bond traders have been told so many times by Mr. Bernanke that rates will stay low, that they have finally come to believe it'.
So in yet another unusual fact in a year of oddities, both higher bond and equity prices can be right at the same time. The economy will probably not recover quickly, but even if it does, rates will stay low and bond prices high.