What's the deal with the bonds?

No, this is not a Seinfeld-like opening to a comedy bit. I'm talking about this eye popping rally in bonds that has sent the 2 year hitting record low yields day after day and the 10 year back to March 2009 levels. Is the bond market signaling double dip? Well, as I made mentioned a few weeks ago, I think there's more than just a flight to safety trade going on in bonds. The bond market is clearly signaling strong deflationary pressure is imminent which goes hand in hand with a weakening economy. So again I ask, is the bond market signaling a double dip? With the short end of the curve at 0% unfortunately, the yield curve can't get inverted to give us the reliable recession warning that it historically has been able to provide. In such a scenario when the short end is at 0%, I've always said to myself that a break below 3% on the long end (10 year) should be considered a dangerous sign and inversion-like but it's not per se because an inversion implies tight monetary conditions which tends to put a break on economic activity tipping it towards recession. Monetary conditions are clearly not tight overall. There is still a positive yield curve spread albeit a shrinking one. But it's hard for even the staunchest optimist to argue against the notion that the bond market is at the very least signaling soft patch in the economy (correctly or not).


Determining the implication of the bond market on equities is not so clear cut in my view. Generally speaking, a declining interest rate environment is positive for equities because it enhances valuations from the perspective that future expected cash flows become more valuable as they are discounted using a lower discount rate and lower interest rates is stimulative for the economy. But on the other hand, a low interest rate may be a harbinger of significant disinflation or deflation which goes hand in hand with a weak economy and although expected cash flows are discounted at a lower rate, the expected cash flows themselves end up shrinking significantly as a result of the deflationary pressures/weak economy which is a large negative for equities more than offsetting the positive implications of a lower discount rate.

Therefore, when it comes to interest rates and the stock market, the goldilocks analogy applies here....they have to be not too hot and not too cold to give thumbs up for equities. I believe we are now in the "too cold" territory and should be bracing for weak economic data points to hit the market for the next 1-2 months at least. Remember, the 10 year bond yield hasn't been this low since March 2009 when the economy was at its nadir and everyone was bracing for a depression. I don't think any economic softness will be so bad as to trigger a double dip but it's a definitely a decent possibility so I'll be on guard for it.

There's also the possibility that the big move in bonds has been fueled by a massive short squeeze from bears who thought the European sovereign debt crisis would spread to the US. There's no shortage of bond bears who for years and years have been calling for a collapse in bond prices. I know a friend who got murdered trying to short bonds in 2008 using TBT.

The ironic thing is that from a trading perspective, bonds now actually look to be a good short. As I said previously, the 10 year yield is just as low as it was when the economy was a complete basket case in March 2009. Therefore even if we do get a double dip the bond market has already priced in plenty of weakness and so after perhaps a knee jerk reaction to any surprisingly weak data points it's more likely to see bonds "sell on the news" and head lower. I'd be looking for the 10 year to hit 2.5% before contemplating a short.

We are at interesting junction here. I'm doing my best to be nimble and patient for good set ups. No long term commitments as this point.