What the Bond Market is Telling Us About the Economy

In trying to peer ahead or understand what is currently going on in the economy it’s always a good idea to keep an eye on the bond market. Free of the need to worry about profit performance and for the most part operating in a riskless environment, or at least one in which the risks are well defined, bond traders are focused on little else but the economy so their behavior is especially meaningful.

The shape of the yield curve is one way the bond market speaks to us about the state of the economy. There is a substantial body of evidence that the yield curve is one of the most reliable indicators we have of what can be expected from the economy looking 12 to 18 months ahead. It has essentially called every recession since 1950 except one. If we look at the spread between the 2 year and 10 year Treasury yields (considered by most to be the best spread to use), we see that after rising steadily from 1.31% on June 30, 2012 it rose steadily to a peak of 2.61% at the end of last year, signaling an expanding economy, but then dipped sharply to 2.31% at the end of January and after hovering near that level through the end of April took another dip down to 2.15% today, May 15. This marks a significant break in this important indicator which, if not decisive, is certainly worthy of notice.

The recent plunge in bond yields has confounded the conventional wisdom that has been calling for the 10 year Treasury to rise back up to 3% because of the strengthening economy, some expecting it to rise as high as 4% by the end of the year. Instead, the 10 year Treasury has trended downward from 2.8% in early April, and then dropped abruptly from 2.66% to 2.50% in the last three days alone. As I mentioned in my April 5 blog, the gap between what appears to be the economic reality of 2% growth as far as the eye can see and the stubborn optimism of most economists who insist that we will have at least 3% growth for the rest of this year and probably even better next year is greater than at any time in recent memory. It seems clear now that the bond market is coming down on the side of a less rosy view of the economy, a sentiment that also appears to be spreading among the more serious money managers like David Tepper of the Appaloosa Fund who said this morning, “I am nervous, now is the time to preserve money, now is the time to have cash and a flexible portfolio”. Since Tepper is usually near the front of the herd, his words are worth contemplating.

There is plenty to worry about in this economy. Europe is slipping back and as Tepper also said, “The ECB better ease in June”, while Christine Lagarde of the IMF says there is a 25% chance Europe will be in deflation by next year. Economists keep talking about global growth picking up this year but when we look at the latest PMI surveys we see emerging markets continuing their 4 year slide from readings near 58 down to the current 50 that signals stagnation, with the massive Chinese economy leading the way down.

As for the U.S. economy, to worry one needs only to look at the two sectors that are the pillars of the bull thesis, housing and the consumer. Even Janet Yellen who has become something of a cheerleader for the economy in her anxiety not to let anything slow the tapering that the Fed has embarked upon was forced to admit in testimony before Congress this week that housing “bears watching” because “the recent flattening out in housing activity could prove more protracted than currently expected”. In fact the “flattening” could have been observed as far back as last Summer, but the housing bulls keep insisting that patterns will return to the old normal as household formation rebounds, still clinging to the idea that housing booms are a normal part of the business cycle just as they always have been in the past, and oblivious to the new normal where kids live with their parents longer and when they do move out already saddled with large student-loan debt would prefer to rent and remain untethered by a mortgage on an asset that no longer is guaranteed to appreciate. Even if they are inclined to buy a house, stagnant incomes, rising costs and the need for hefty down payments make it impossible for many to qualify for mortgages under today’s more stringent lending standards. Could it be that housing is behaving as it usually does in the waning months of an economic expansion, and not as a leader that is ready to step up and drive growth just when the economy needs it?

Retail sales braked sharply in April with an increase of only 0.1%, but again economists are reassuring us that consumers have simply paused to catch their breath after rebounding from the Winter freeze and we are still on track for stronger consumer spending through the rest of the year thanks to an improving jobs market. Wages and hours worked haven’t budged, however, and the modest rise in consumer spending has entailed a drop in the saving rate. The biggest components of consumer spending so far this year have been higher utility bills and Obamacare insurance signups. While declines in receipts at electronics and appliance stores, furniture outlets, casual restaurants and drinking establishments restrained sales last month, sales at auto dealerships rose. Auto and truck sales remained brisk due in large part to the abundant availability of credit, including sub-prime credits that are now beginning to see a rise in delinquencies. Apart from automobile financing and student loans that have grown rapidly there has been little increase in credit card and other forms of consumer debt.

In assessing the condition of the typical consumer it is impossible to overlook Walmart, a company that handles about 8 cents out of every consumer dollar. Like all the others, Walmart placed a lot of the blame for their miserable first quarter report on the weather, but Walmart’s record has been miserable for 5 consecutive quarters now and their language about the weather was almost identical to that used a year ago. Same store traffic was down 1.4% and same store sales down 1.2%. It’s too bad that data are not available on consumption by the top 10% whose incomes increased substantially and saw a big increase in the value of their stock portfolios. They undoubtedly spent more freely, which we can see in the reports of retailers addressing more affluent customers, but they are not the typical Walmart customer. Walmart serves the vast majority of the lower and middle class customers and their performance tells us more about the condition of consumers than the aggregate data standing alone. Walmart and other discount stores have seen weakness for several quarters now as their core lower income customers struggle with limited wage gains and the withdrawal of benefits like unemployment compensation and food stamps. That Walmart, a company that has aggressively invested in lowering prices should be having so much difficulty getting consumers into their stores and spending money speaks volumes about the condition of American consumers and what the economy can expect from them in the near future.