QUESTION OVER STRENGH OF RECOVERY / THE FINANCIAL TIMES ( HIGHLY RECOMMENDED READING )

Questions over strength of recovery

By Michael Mackenzie

Published: August 26 2009 19:53

Amid the thin trading volumes of a typically sluggish August, investors have been caught off balance as the normal relationships between US equities, government bonds and commodity prices have broken down.

At the end of July, the S&P 500 equity composite was below 1,000 points and the price of crude oil loitered below $70 a barrel. During August, the S&P and oil have risen to their highest levels in 10 months, amid hopes of a sustained recovery in the economy.

In contrast, the yield on 10-year Treasury notes has made a circular journey, rising from about 3.50 per cent at the start of the month, peaking near 3.90 per cent in early-August, only to be trading about 3.42 per cent on Wednesday.

“Something has to give when all you see are green arrows for prices across the major asset classes,” says George Goncalves, head of fixed-income strategy at Cantor Fitzgerald. “Strong commodities and stocks with falling bond yields cannot continue, at some point the normal relationships should resume.”

The breakdown between equities and bond yields reveals how divided investors are over the sustainability of the economy’s recovery.

While some equity research touts a V-shaped recovery for the economy, bond investors believe the economy will only derive a short-term boost from the replenishment of inventories. Beyond a bounce in activity this year, the debt-laden consumer is in no position to pick up the baton and accelerate the recovery into 2010, many argue.

“It may well be that more [bond] investors are signing on [to] the ‘sugar high’ from stimulus thesis and [are] worried about what crash lies beyond the boost from homebuyer tax credits, cash-for-clunkers and other temporary/transitory props for the US economy,” says Bill O’Donnell, strategist at RBS Securities.

The release yesterday of durable goods orders for July highlighted the dichotomy, with the headline number exceeding forecasts, while capital goods orders excluding defence and air orders fell 0.3 per cent, the first decline since April.

Not even a deteriorating debt outlook by the White House and Congressional Budget Office, with the budget deficit seen rising a further $2,000bn over the next 10 years, has derailed the bond market’s rally. Recent auctions of new debt by the US Treasury have attracted solid demand from foreign central banks and investors, limiting concerns about the rising tide of new supply.

That comes amid deep misgivings in some quarters about the quality of the S&P’s rise of more than 50 per cent from its low in March. That rally represents the strongest rebound in stocks since the explosive short covering rallies of the 1930s when the market rose more than 100 per cent.

Equity volume has been low, while the best performing stocks, such as AIG, Fannie Mae, Freddie Mac and Citi, have generally been those that were heavily shorted during the depths of the sell-off.

The rally in both Treasuries and stocks has caught some trading rates desks offguard and that has only boosted bond prices as dealers have reversed their lossmaking trades.

But an even bigger trap could be brewing for investors banking on stocks following their usual September to October pattern of performing poorly.

“As seasoned investors surely know, September has historically been the worst month for the market during the year,” say analysts at Bespoke Investment Group. This could explain why bond investors are driving yields lower.

“Everyone we speak with is keeping powder dry for the stock market weakening next month and during October and I think bond yields are falling ahead of that move,” says Tom di Galoma, head of Treasury trading at Guggenheim Partners. “One market is completely wrong and if equities don’t turn lower, then they could run quite considerably as money moves off the sidelines.”

That could also spark a dramatic reversal in Treasury yields. However, expectations that inflation will continue falling makes bond yields look attractive, particularly when the 10-year note approaches 4 per cent.

“The economic data has been better, but we are not looking for the economy to experience explosive growth next year, while many global indicators point to disinflation,” says Bill Strazzullo, chief market strategist at Bell Curve Trading. He said weak labour hiring trends, falling real estate values and excess capacity in manufacturing would keep prices contained and boost the appeal of owning bonds.

Then there is the performance of credit, which has generated huge returns for investors since the start of the year, with high-yield debt alone up 40 per cent. The lower end of Investment grade credit spreads have contracted more than two percentage points to 6.5 per cent since April, the lowest level since the start of 2008.

Credit has lagged behind the rise in equity prices and that has some analysts thinking that this helps explain why yields have fallen, while stocks have risen.

“We have seen an asset allocation out of credit, because it’s had such a good run, and that money has gone into Treasuries,” said Gerald Lucas, senior investment advisor at Deutsche Bank.

Another aspect of the financial crisis has been a narrowing of options for investors, with many investors preferring to place their money in liquid markets. The combination of rising risk tolerance and enormous amounts of liquidity supplied to the financial system by central banks, may explain why asset classes are rallying in unison.

“There is so much money in the system and it appears anything with a price is going up as people put cash to work,” says Mr Goncalves. “It’s perplexing to see different asset classes going higher in value.”

It is indeed a trend that has plenty of people scratching their heads and warning it cannot last.

“I would argue that if the recovery is sustainable then eventually rates at the short end will have to rise, and inflation expectations from the massive monetary stimulus will push rates higher in the longer maturities,” says John Prior, technical analyst at Killik Capital in London.

“Unless we are going back to the Goldilocks economy of inflation-free growth, I don’t believe the current situation can continue indefinitely.”

Copyright The Financial Times Limited 2009.