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Keep a Close Eye on the Bond Market

July 11, 2011
With the US recovery again in doubt, it's more important than ever to watch the bond market here.

Friday's jobs report was a great banana peel on which Mr. Market slipped.

Via The Wall Street Journal:

The US economy barely added jobs for the second month in a row in June and the unemployment rate rose to the highest level this year, dashing hopes the economic recovery is getting back on track and putting pressure on policymakers to react.

Non-farm payrolls rose 18,000 last month, far less than expected, as small gains in the private sector were just enough to outweigh continued government job losses, the Labor Department said Friday.

The day before the report, employment numbers from ADP (ADP), a private data source, suggested that non-farm payrolls would be strong. That turned out to be a massive head fake.

Our long-run thesis has been, and continues to be, that the stimulus-led recovery is more or less false. Speculative assets have been driven up on the "sugar high" of false hopes and currency debasement.

Meanwhile, China and Europe are slowing down too — and red-hot emerging markets like Brazil are showing signs of overheating. (The Economist magazine recently created an "overheating index" in which Brazil, India and Hong Kong were in the extreme danger zone.)

What does all of this mean?

First: For a brief shining moment, there was hope that even if the rest of the world was slowing down, the US was gaining ground again. That hope was dashed by Friday's news.

Second: Deflation, not inflation, is still a legitimate fear, and that means US Treasury bonds could still march higher — with interest rates falling correspondingly lower.

As you likely know, there are many observers just anxiously waiting for the US Treasury bond market to collapse. They may have to wait a good while longer yet.

Along with gold, US Treasury bonds are one of the last remaining "safe haven" asset classes on the planet. That means that money floods into bonds when investors get scared. And when the price of bonds goes up, long-term interest rates go down.

Rising bonds (and falling interest rates) are a harbinger of deflation. When investors buy government bonds at nosebleed prices, they are expressing the view that other assets are not attractive enough, or too risky to mess with.

A willingness to lock in low yields (which is what expensive bonds offer) further telegraphs the opinion that the economy will stay weak. (If strength was expected, interest rates would be expected to rise, and bond prices to fall.)

All of this suggests that US Treasuries are a bellwether here. If USTs keep going up, that is bad news for the economy and the stock market. In Japan, the value of the Nikkei index fell by 75%, even as the price of 10-year notes rose until yields hit 1%.

If the US 10-year note saw yields fall to 1% (from their current perch above 3%), the S&P and Dow would surely fall below their March 2009 lows. That would be a nightmare for bulls.

More important, however, is the question of whether or not the US economic recovery is stalling (and what investors on the whole believe).

Putting aside risks of the debt ceiling fight, bonds could keep rising if the economy keeps sputtering. If the recovery meme picks up again, however, long bonds could fall back into decline.

This makes IEF and TLT, the exchange-traded funds for 10-year notes and 30-year bonds respectively, a pair of instruments worth monitoring.

Written by Justice Litle for Taipan Publishing Group. Additional valuable content can be syndicated via ourNews RSS feed. Republish without charge. Required: Author attribution, links back to original content orwww.taipanpublishinggroup.com.

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