Will Bonds Determine The Market's Trajectory?

Includes: DIA, GLD, QQQ, SLV, SPY, TIP
by: Bio Insights

There has a been a lot of analysis focused on the inflow of worldwide capital in the US dollar-denominated bonds. The most liquid and "safe" of these, of course, are US treasuries. In a recent article, I created a very simplistic model to compare the returns of two investors.

In a nutshell, it implies that there are no reasonable inflationary scenarios where treasury bills would offer better returns than a portfolio containing the 5 "Dogs of the Dow" in terms of yield alone. The changes in principal value of the bonds and values of the shares are ignored, along the possibility that dividends are cut.

Traditionally, treasury yields would beat dividends due to their inability to appreciate in value (with the help of deflationary pressure that is). This operates along with the assumption of an ever-increasing money supply, which the fed has supported well to match its inflation target. Nonetheless, we are clearly in deflation territory. TIPs yields (which are supposed to show the real yield of these bonds) are deep in deflationary territory. You can find updated rates at the US Treasury.

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A little over a year ago, the financial markets were much more worried about this:

We've switched our minds from "massive tidal wave of inflation" to "moderate deflation for years on the heels of weakness in Europe and China". Something like that.

The yield curve is also quite flat due to operation twist, among other things (and possibly set to get flatter). Although I feel that banks would worry about this more than the other sectors of the economy, some interesting research at the New York Fed says this is an accurate way of predicting economic cycles. Apparently, bond market conditions currently imply that are that 1-yr recession risk is ~3.75%

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For the most part, recessions became probable when the yields got too flat. But nowadays, the only problem is that the nominal yields have gone far too low (short term treasuries are only a hair above zero in yield). If we experience more appreciation in long-term t-bills, we will narrow the spread and theoretically heighten the possibility of recession later.

Ultimately, the theory doesn't account for an innumerable number of external factors, and I think there's a more practical way of viewing what could be going on. This article explains it in detail, but simply put the twist is probably being used to tackle the US debt scenario through a significant reversal of inflation expectations down the road. It's a dirty trick against the bond buyers, but makes sense.

Since the fed is artificially changing the landscape of the bond market and making it difficult to understand its intentions (and the effects of its operation), I tend to focus on more fundamental ideas that are less prone to artificial movements - primarily the nominal yields versus realistic inflation expectations. These currently point to unsustainable levels of deflation.

Recent action in the stock market has been quite bearish. If we haven't made a bottom for the year, we are set on having the 50-day moving average crash through the 200-day moving average. The last time that occurred (in 2011), it was a disaster.

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Everything should be a lot more clear after Wednesday, when Bernanke speaks. If we do end up with another operation twist, I will not be all that optimistic about its true effects on our economy, especially in the financial sector, but I will appreciate any increases of money supply (as a commodity bull). Gold and Silver should benefit.

If the fed does not choose to intervene, there's a good chance we will see yields stay in their general vicinity until Europe and China improve. If (when) this reversal does come, the stock market should have enormous upside potential on this alone. The difficult part is determining when to buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.