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The entire system is in limbo

|Includes: SPDR S&P 500 Trust ETF (SPY)

For much of the last month, I’ve been very bearish on the short term outlook for treasuries, and I still am. Yields on the United States treasuries are at an absurdly low level, last seen in 2008 when the entire financial system was on the brink of collapse. As the days go on, more and more market professional and analysts are predicting that the entire bond market is in a huge bubble and is standing on the edge of a cliff. As likely as they may seem, these low yields are now going to be the norm for the next few years. Don’t get me wrong, at the pace money has been flowing into treasuries, there is bound to be a short term pull back and we could easily see 30 year yields at 5% in the very near future, but how long can we expect them to stay at those levels, especially with the economic outlook for the country so gloomy. A short term rise in interest won’t hide the long term problem the United States is facing. The bond market is in a bubble that no one doubts, but that bubble isn’t bursting anytime soon.
Let’s face it; the markets have entered a stage of limbo, where you can’t turn to anywhere to get a safe, adequate return. Not only are treasuries offering horrendous yields, equity markets are failing to appeal to a lot of institutional and individual investors due to companies holding onto their cash and not willing to pay out strong dividends.
S&P 500 Dividend Yields

S&P’s dividends are still facing record lows. Since the March 09 bottom, equities have rallied immensely, and many companies whose futures were in doubt have been beating earning expectations quarter after quarter, yet there is no willingness of these companies to raise dividends and instead keep the cash on their books.
S&P 500 P/E Ratio

Historically, a P/E ratio of 20+ for the S&P 500 has proven to be too high for the market and the prices in relevance to earnings have fallen following such periods. The equities market pulled back again after briefly crossing P/E of 20 this year. With a historically high P/E ratio and historical low yields, the broader equities market doesn’t look that attractive.

10 Year Yields

Bond yields, as unattractive as they are, have been even lower than their current level in their history. In the 1940, 10 year treasuries hit their all time historic low of just a couple of basis points below 2%. Since then, bonds have never really threatened to be that low, until the past two years. But there is something significantly different about the unattractiveness of bond yields in the 1940s compared to today. When bond yields bottomed in the 40s and money started moving out of the bond market, the stock market looked extremely attractive. The S&P 500 yielded close to 8% back when treasury yields bottomed, compared with 2.05% today, and had a P/E ratio of just below 10, compared with 19.75 of today. So you have to wonder. Is the bond market really that expensive? Is the stock market really that cheap? Or are they both nothing more than a suicide mission?
The mess that has been created by the recession of 2007-2008 is one that is going to be really tough to clean up. Unemployment number sit at 9.5%, but anyone who has been in America long enough knows that even those numbers are sugar coated. And unless there is sufficient number of jobs in the economy, a recovery will never be sustained; no matter how many stimulus packages the government presents or how many dollars the Fed pumps into the economy. In the short run, will we dip into another recession? Who knows? But we all know what we face isn’t a short run problem, but a long run problem. The economy is on the brink of deflation and Bernanke has absolutely no idea what to do. As an after math of the financial crisis, the Fed was forced to lower interest rates to 0% in order ease the flow of capital throughout the economy. Then the fed spent billions of dollars to bring even more money into the system through the purchases of MBS and such, and the US government followed with TARP, and various other stimulus programs. Yet two years later, here we are in the same situation. High unemployment, banks not lending, money not flowing in the economy, houses not being sold, and now we face the threat of deflation. The Fed knows it can’t contract the money supply, nor can it raise it any more due to fears of hyper inflation, so it plans to use the proceeds of its maturing MBS to purchase US treasury debt to at least keep the money supply stable. This will thus keep the demand for treasury high for the short run, and there it is highly unlikely the Fed will raise interest rates let alone in an economic period like this, but also with billions of dollars of bonds in its balance sheet that will lose value if rates are to go up.
If our economy is to go into deflation, bond rates will not go up as everyone expects them to. However, an ultimate fate of rapid inflation in the near could be disastrous for our economy because Bernanke cannot afford to raise interest rates with the condition the job and financial markets are in right now. No one running the system knows what to do because we have caused our self to stand in the middle of a ring of fire that is closing in on us, where there is no exit to it besides running through one corner of the flames and getting brutally burned in the process.

Disclosure: No positions