Gary Shilling. (Photo via Gary Shilling)
There is no shortage of investors shrugging off the latest leg lower in U.S. Treasury bond yields, saying heavy central bank involvement in this part of the financial market make such moves less of a signal that the economy or that equities are headed for trouble.
That interpretation would be a mistake.
Recall that yields on 30-year government bonds started to decline on Jan. 2, anticipating the fallout from the budding coronavirus crisis that had taken hold in China.
Yields fell from 2.34% on that day to 0.94% on March 9, as the price of the benchmark 30-year bond leaped 29%. Only on Feb. 19 — seven weeks later— did the S&P 500 Index begin its 35% slide.
Fast forward and 30-year yields have fallen from 1.66% on June 8 to a recent 1.19% as their prices climbed 9%. The question is whether stocks will follow again, and with a similar lag of about seven weeks.
The fundamental economic scene favors a repeat.
The situation is ghastly, with Covid-19 infections accelerating and plans for physical classes at many schools, colleges and universities this fall risking further contagion. Staying closed or holding virtual classes, however, promotes dropouts, pressure to cut tuition and fees and financial disaster for many schools.
Then there are the problems of reopening businesses, re-establishing and reorienting supply chains and encouraging many to return to work who are now paid more by federal and state unemployment benefits than when they were employed.
The recent Treasury bond rally fits with our forecast that the recession has a second, more serious leg that will extend well into 2021, despite massive monetary and fiscal stimulus. Declining business activity saps private credit demand and makes Treasuries shine as havens.
A deep recession also breeds deflation to the benefit of Treasuries. The government said Thursday that its core personal consumption expenditure index, which is what the Federal Reserve uses to track inflation, fell 1.1% in the second quarter.
Over the entire post-World War II era, the correlation between Treasury bond yields and inflation as measured by the Consumer Price Index is 60%.
This is remarkably strong considering all the other possible influences on long-term interest rates such as federal budget deficits, wars, consumer sentiment and spending, and government actions. My forecast of Treasury bond yields starts and ends with my projection of inflation.
The spread between 10-year Treasury Inflation-Protected Security yields and conventional 10-year Treasury yields, which is what bond traders expect inflation to average over the life of the securities, recently dropped to a miniscule 0.50% from 2.5% in 2012.
