The price action in different asset classes can give more reliable indication of the direction of economic activity and price increases in an economy. However, in the recent past, gold and Treasury bond yields have been giving conflicting signals on the economic and inflation front.
This article looks into the price movement for these asset classes and the possible conclusion one can draw from them regarding inflation and the extent of weakness in the economy.
Starting with the 10-year Treasury bond yield, the yields touched a 60-year record low of 1.91% on Friday’s trade. As the chart below shows (click to enlarge), the yield touched a low of 2.07% in December 2008. During this period (September 2008 to March 2009), the economy was in a freefall. Therefore, it was natural to see high degree of risk aversion and falling yields.
The interesting thing to note is that the current yield on the 10-year bond is much lower (1.91%) than the yield seen in an economic freefall.
Does this mean that we are headed for another major recession? Or, does this mean that there is some other, more serious factor (which we are not aware of), which is leading to such a big demand for Treasuries?
I can try to answer the first question by looking at the trend in equity markets and gold. Another major recession would mean greater fears of deflation. A record low Treasury yield might justify that fear. However, gold at near record high levels is an indicator of inflation.
As evident from the chart below (click to enlarge), gold was trading at USD855 an ounce in December 2008 when the 10-year Treasury bond yield was at 2.07%. Further, gold had corrected during the second half of 2008 on deflation fears.
Clearly, the trend we see currently is conflicting. Gold is at record highs suggesting inflation, while Treasury bond yields are at record lows suggesting deflation (or no inflation).
To answer my question above, we might not be headed for another major recession (or even a recession at all).
Then why are 10-year Treasury bond yields trading at 60 year lows?
Are we headed for another major banking crisis or euro zone sovereign debt crisis?
What is making investors rush to safer investments like U.S. Treasury bonds?
Before I try to figure out this answer, there is also another major price conflict in the Treasury bond yield itself. For this, presented below is the chart of the 30-year Treasury bond yield. Click to enlarge:
As is evident from the chart, the 30-year Treasury bond yield also touched a low of 2.55% during December 2008. As mentioned above, the 10-year bond yield on the same date was also at its low of 2.07%.
Currently, 10-year bond yields are 16bps lower than the December 2008 low. However, the 30-year bond yield is still 70bps higher than the December 2008 low.
There can be two reasons for this:
The first is that markets might be expecting some downturn along with lower inflation in the near-term and relatively higher inflation in the long-term. However, near-term gold prices don’t support this argument. Gold should have corrected meaningfully for this argument to hold up.
The second reason might be stemming from the Central Bank’s announcement to keep Fed Fund Rates at record lows until mid-2013. With no fear of rising interest rates in the near-term, corporate and other investors could be taking loans at near-zero rates and buying bonds for near-term gains (almost assured).
However, there is no doubt that the buying in Treasury bonds is partly due to a slowing economy. Further, the sovereign debt crisis in the euro zone makes the dollar and Treasury bonds look much safer.
One can make a case that market participants are preparing for an even worse scenario in the euro zone than we are currently experiencing.
At the same time, higher gold prices might be telling us about the loss of confidence in paper money even in a weak economy (which might lead to deflation). I would like to add here that avoiding gold in the near-term might be a good idea.
In conclusion, regular intervention in the free markets by governments has created more confusion and strange price movements in some asset classes. It would not be surprising to see correlation between some asset classes change significantly in the foreseeable future.
This would lead to an even more difficult investment environment. For now, things look very murky and a wait and watch strategy might help.