The Capital Spectator: THE SPREAD SHALL SET YOU FREE
A friend of mine who works at a hedge fund told me this weekend "Everyone's short the 10-year" Of course that just couldn't be possible with yields hitting new lows everyday. In stocks when "Everyone is short" a security, it's often a good time to buy as there is a deep amount of pessimism already built in, and once things turn around slightly short-covering can produce lots of momentum. But the steady ascent of the T-bill doesn't look like short-covering. In a rising-rate environment, could the increase really be the result of an irrational buyer? China? If not, then one can't speak of "Everyone thinks this" for market prices are really the only way to gauge consensus. Or perhaps the market itself has two different viewpoints:
Each is saying something materially different from the other, or so one can argue. The Treasury market, if we may be so bold as to assume prescience, tells us that the economy will err on the side of slower growth in coming quarters. Or so the 10-year's stable/falling yield implies. Entwined in that forecast is the assumption that inflation won't amount to much after all. Even today's producer price index, which rose by a higher-than-expected 0.6% in April, is of little consequence, traders of Treasury appeared to be advising the rest of us today.
But the junk-bond market would have you believe that inflation is something to lose sleep over and economic growth may be materially better than anticipated. The complication, of course, is that high-yield bonds aren't a full-fledged card-carrying member of the bond guild. Given their low credit-rating status, junk is viewed by Mr. Market as a love child born with the genetic makeup of both equity and debt. All of which suggests that the sell-off in junk bonds may be less about the future path of yield and more about the concerns of the underlying health of the corporate issuers. In fact, if one views the recent history of high-yield bonds by price, which moves inversely to yield, the junk chart looks more like the stock market, ergo, a market that's been falling.
Here's some more color on the question, from a stock-market perspetive from Barry Ritholtz
What’s behind this? As mentioned last week, it’s a belated recognition that growth has slowed while inflation has not. However, despite all the “stagflation” chatter we’ve heard lately, we do not believe we are in any danger of those specific unpleasant circumstance. Rather, I suspect we should prepare ourselves for a case "demi-stagflation" – anemic growth and robust inflation. I expect this condition may persist through out the rest of 2005.
True stagflation is far less likely than has been feared. The current environment simply isn’t conducive to the unusual economic numbers of the 1970s. I doubt we will see 7% inflation and a 1% GDP rate anytime soon. But that doesn’t mean the environment is ideal; far from it. We may possibly see GDP at 3% or just below, while inflation is at 3% or just above. That translates into Growth just a little bit too soft, and Inflation just a little bit too robust. The fact that both economic indicators are on the edge of being acceptable is why the market has been such a battle lately. Neither side has the clear advantage. Hence, the churning and directionless affair we have all been suffering thorough.