Those who track the markets commonly describe stocks and bonds as arguing about the economic future — with the odds typically tilted toward bonds, for their tight focus on the core macro forces and record of prescience.

The headlines are familiar:

“Bond Markets Have a Message About the Economy That Stock Investors Might Not Want to Hear”

And:

“The Bond Market Is Giving the Stock Market a Stern Warning”

This foreboding signal of economic weakness purportedly comes from stubbornly low 10-year Treasury yields and a narrowing spread between short and long rates at a time of buoyant equity indexes.

But here’s the thing: The first headline above is from June 2016, the second from June of this year. Stocks and the U.S. economy have done just fine in the interim; the S&P 500 has climbed at a 15 percent annual rate since both those dates, up 25 percent since June 2016 and more than 8 percent the past six months.

The 10-year Treasury is, in fact, higher now than at those moments over the past 18 months when it seemed its skimpy yield was wagging a finger at stocks and admonishing them to “be careful.”

Yet much talk on Wall Street today again involves the stickiness of that 10-year note under 2.4 percent, and the compression of its spread to two-year Treasurys to below 0.55 percentage points, despite a peppy run of economic growth here and abroad and swelling investor risk appetites in other markets.

So is there any reason to think now that the bond market is conveying an alarming message that should be heeded?

Probably not — at least no urgent warning of distress particularly soon. There are several big-picture reasons yields are still subdued despite years of predictions for them to race higher, and they don’t include “the economy is in trouble.”

First, demand for U.S. Treasury paper is persistently strong in a world suffering a relative shortage of safe yield.

The German 10-year note yields around 0.3 percent, leaving its American counterpart a full two percentage points higher and unable to widen that gap more.

Hedge-fund manager Mark Dow, who also blogs at Behavioral Macro, points out that there is very little triple-A rated corporate debt in circulation after ratings-agencies turned stricter. Vast amounts of capital is wielded by price-insensitive institutions, from insurers to pension plans to banks, which are now required to hold more high-quality securities. And, of course, central banks are holding trillions in government debt.

This makes the 10-year Treasury a balky gauge of cyclical economic prospects, Dow argues in a blog post:

“This isn’t to say yields don’t react to economic info or don’t say anything about the state of the economy. Of course they do. But the dominance of financial drivers after 30 years of global financial deepening has made attempts to extract economic information from the level and shape of the US yield curve unhelpful–or worse, vulnerable to false positives.”

A “false positive,” in this case, would mean an untrustworthy signal of sharp economic slowdown.

It’s worth noting that in the past week or so, as the 10-year yield has ebbed and the yield curve pressed to new lows for this cycle, bank stocks have held up well and utility and REIT shares have sagged.

Might this be the equity market’s way of looking through the current bond action, betting the economy will be good enough for a run of Fed rate hikes and implying that a rush to much lower long-term yields is not in the offing?

Second, bond yields also might simply be saying consumer inflation is low and is likely to remain so. The whole story of aging populations and galloping technological disruption isn’t new but still persuades.

Cathie Wood, chief investment officer at growth-stock shop ARK Invest, has pointed out that in the late 19th century the yield curve was flat for years thanks to an innovation-driven deflationary economic boom.

The two-year Treasury is driven by Fed rate-hike expectations for the next several quarters. The ten-year is influenced by the longer-term outlook for inflation’s effect on bondholder returns

Third, perhaps the squeezed yield curve is also about the economic cycle simply pushing into a later phase, but not yet nearing its end.

If that’s the case, and Treasury prices are set up for a few more rate hikes before the Fed tightening cycle is done, we could be six months to two years away from the economy tipping into recession. Importantly, corporate high-grade and speculative-grade debt are priced at sturdy levels, a virtual “all clear” from the credit markets about the underpinnings of the economy.

Strategist Tony Dwyer of Cannacord Genuity notes that over the past three cycles, once the 2-to-10-year Treasury spread narrowed below 0.6 percentage points, the median S&P 500 gain to the ultimate market peak was around 60 percent, and a recession was “at least two years away.”

Only three cycles might not be statistically airtight. And this has been an unusual cycle, with rates kept near zero for years and markets having outperformed the economy for much of the time. So maybe such “rules” won’t be followed too closely.

But it’s at least some comfort to those hearing shrill warnings about what bonds are supposedly telling us.

Source: Investment Cnbc
No, bonds aren't signaling economic trouble ahead. Here's why