Bonds and Equities: Upstairs, Downstairs

by Paul Springer

Both the treasury  and equity markets have acted as expected, with bonds spiking and equities basically imploding. A flight to safety ended, as it always does, with bond buying, which effectively pumped capital into the same market whose credit issues sparked the equity rout in the first place. But any port in a storm – as we heard one trader put it, U.S. Treasury bonds are “the cleanest shirt in the laundry basket.”

For the record, that seems slightly insane. But you can’t bury your cash in the back yard. Yet.

Monday’s buying drove the 5-year Treasury yield down from 1.32% at the end of last week to 1.15%, and longer term U.S. government bonds also saw prices rise and yields fall. You earn a mere 2.4% for lending the government your money for ten years, easily less than the inflation rate.

Fear drove some to Canada, Dow Jones says, but the U.S. yields – and confidence in our ability to pay them – were a stronger draw.

“AA-plus is the new triple-A,” TD Securities chief Canada macro strategist David Tulk told Dow Jones. Oboy.

Given the various economic perils tormenting investors, the flight to quality is unsurprising. How low can people go before they run screaming back into equities, commodities, or something else? It’s a good question, since real yields are basically negative at this point:

Analysis from Bloomberg says the U.S. inflation rate has edged up to 3.6% in June, a possible indication of overpricing.

Other measures such as real yields show investors aren’t being compensated enough for inflation. The yield on the 10-year Treasury note was lower than the pace of consumer price increases for a third month in July. The gap reached 1 percentage point Aug. 2, the most since September 2008, which was also the last time inflation was higher than 10-year yields for three months.

To some extent, that “something else” may be some other kind of debt securities.

But not distressed debt, if today was any indication. Few buyers want to strap on more uncertainty, Dow Jones says:

In the secondary market, prices of these debt instruments fell sharply on light trading showing that some investors were selling. However there was a lack of buyer appetite except at discounted values.

OK, so risk is off. How about munis, then? Despite their ugly underwriting scandals and ties to states with bruised economies, municipal securities were on the buy list Monday, when buying drove down yields on high-rated stuff by 2-4 basis points. Capturing the zeitgeist was MMD analyst Randy Smolik, who told Reuters, “It’s still kind of squirrelly out there.” Indeed.

And in Canada, spreads between Canadian and U.S. debt widened further in favor of the U.S., but Dow Jones says Canadian issues rose from Friday’s prices, depressing two-year yields from Friday 1.056% to 0.822% Monday.

Meanwhile, the world awaits the effects of further intervention by the U.S. and a variety of countries in Europe. So far, The Wall Street Journal notes, no one has had stellar success:

What euro-zone policy makers don’t seem to understand is that through these successive failures, they have lost what credibility they once had. So if it didn’t work the first three times, it’s even less likely to work the fourth, fifth and sixth time. As Albert Einstein once observed, the definition of insanity is doing the same thing over and over and expecting a different result each time.

For those interested in different ways Einstein’s remark could play out in the U.S., see Reuters‘ excellent analysis of the Fed’s available weapons here.

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