SOME FED GOVERNORS ARE WORRIED ABOUT DEFLATION -- NEGATIVE PPI DOESN'T HELP -- FALLING BOND YIELDS CAST DOUBT ON RECENT STOCK BOUNCE
JUNE MINUTES SHOW DEFLATION FEAR ... Wednesday's market bounce stalled on release of the Fed's June minutes that lowered the estimate for the U.S. economy for the balance of the year. Also reported was a number of Fed governors that expressed concern about the growing threat of deflation. That may also explain why bond prices rose sharply on the day. The "D" word has been showing up more in the financial media and I've written about it as a dominant theme for the last decade. [Deflation occurs when prices turn negative. Today's -0.5% June month-to-month PPI report feeds into that fear]. Here's why deflation is a problem. The Fed can control inflation by raising short-term interest rates. It's done that many times during bouts of inflation (which has often resulted in a slower economy and falling stock prices). Deflation is tougher to combat and requires that the Fed lower interest rates. Problem is short-term rates are already near zero. So there isn't a lot the Fed can do to combat a deflationary threat. That's why deflation is harder to fight than inflation. The asset class that benefits most from deflation is bonds. Two that don't are stocks and commodities (gold being an exception). As I described in my 2004 book on Intermarket Analysis, stocks and commodities also become closely correlated in a deflationary environment (while bond prices rise). That's certainly been the case over the last two years as shown in Chart 1.
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Chart 1
BONDS HAVE DONE BETTER THAN STOCKS SINCE 2000... Rising bond yields (falling bond prices) hint at a stronger economy and some inflation ("some" inflation is a good thing because it allows companies to raise prices). Falling bond yields (rising bond prices) are usually associated with a weaker economy (with less inflation) and a weak stock market. At least, that's been the case over the last decade when deflation pressures from Asia started to have a global impact. That may explain why bonds have done better than stocks since 2000. Chart 3 plots a ratio of the 10-Year T-Note prices (UST) divided by the S&P 500 since the start of 2000 and shows that bonds did better over the entire decade. The bond/stock ratio rose from 2000 to the end of 2002 after the dot.com meltdown, and fell from 2003 to 2007 as the stock market rallied. The ratio turned back up during 2007 (at the start of the subprime crisis) and hit a record high in early 2009. After falling during 2009, bonds have outpaced stocks in 2010. Chart 4 shows the bond/stock ratio turning up this spring which means that the stock market and the economy have taken a turn for the worse. Since bonds help predict turns in the economy, it stands to reason that they often predict turns in the U.S. stock market as well. That's why I like to compare the two to see which is telling us the truer story
Chart 2
Chart 3
BOND YIELDS OFTEN LEAD TURNS IN STOCKS... My June 24 market message wrote about the change in the relationship between bonds and stocks starting in 1998 and continuing to the present day owing to global deflationary pressures. That same message also explained that falling bond yields since 2000 have proven to be bad for stocks. [My July 1 message also wrote about deflationary trends coming from the onset of Kondratieff Winter in 2000]. So this isn't a new theme. I thought it worthwhile, however, to take a look at how well Treasury bond yields have done over the last decade anticipating (or confirming) turns in the stock market, and why that has relevance to our current situation. Chart 4 compares the trend in the 10-Year T-Note Yield (green line) to the S&P 500 (red line) since the start of 2000. The first obvious impression is that both lines have generally risen and fallen together over the last decade. [So as not to get confused, remember that bond "yields" fall when bond "prices" rise. Just as bond prices and stocks have trended in opposite directions over the last decade, bond yields and stocks have trended together]. A second point worth noting is that bond yields turned down before stocks during 2000 (January versus March or August) and again in 2007. Notice the "negative divergence" between bond yields (see arrow) and stock in mid-2007. There again, bond yields broke down first. We're seeing a similar negative divergence in 2010.
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Chart 4
FALLING BOND YIELDS HINT AT WEAKER STOCKS ... Chart 5 compares the bond yield (green line) to stocks (red line) since the end of 2008. Notice first that the 10-Year yield turned up in December 2008 which was four months before stocks bottomed. Both then rose together until the spring of 2010. The bond yield formed a "double top" at the start of April near 4% (see arrows) which formed a negative divergence between bond yields and stocks, and gave an early warning that the stock rally might be ending. Chart 6 shows the 10-Year Yield peaking about a month before stocks in April and falling to the lowest level in a year. Given the close correlation between the two markets over the past few years, it's doubtful that the current stock bounce will amount to much until bond yields start to rise as well. So far, there's no sign of that. Apparently, bond investors are still worried about a weaker economy and maybe even some deflation. That's a good argument for staying in a defensive market posture with a reasonably good exposure to bonds.
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Chart 5
