Treasuries Signaling Economic Downturn, Not a US Default

Posted by urbandigs

Sun Jul 31st, 2011 10:52 AM

A: The markets will always be all about confidence. Short term confidence and investors perception of confidence in risk assets. How investors perceive short term news and events, may vary. Which is why we have the markets themselves to give us the signals to interpret. Credit spreads will tell us about confidence in the banking system. Stocks will tell us about confidence in future earnings. Bond yields will tell us about confidence on future default risk. Gold will tell us about confidence in fiat currencies and global central bank policies. Right now, the talk of the day is confidence in the US govt's ability to pay back its debts and implement structural reform to control the national debt and entitlement programs. The ultimate fear is a mass selloff in US Treasuries leading to a spike in interest rates. But right now, US Treasuries are pricing in a likely US economic slowdown and not a US gov't default.

10 year US Treasury yields are at the lowest levels since last November, take a look at the chart on the right courtesy of tenyr.jpgThat chart screams of 'risk off' money that is looking for safety due to the expectation of another economic downturn.

While the headlines in mass media swarm around the US debt ceiling, many missed how bad the recent Q2 GDP reading was & the huge downward revisions to GDP readings going back to 2007 - apparently the downturn was worse than we previously thought. Bloomberg reports, "U.S. Economy: Growth Trails Forecasts as Consumers Retrench":

The U.S. economy grew less than forecast in the second quarter, after almost stalling at the start of the year, as consumers retrenched.

Gross domestic product climbed at a 1.3 percent annual rate following a 0.4 percent gain in the prior quarter that was less than earlier estimated, Commerce Department figures showed today in Washington. The median forecast of economists surveyed by Bloomberg News called for a 1.8 percent increase.

Economic growth in the first quarter was revised down from a 1.9 percent prior estimate, reflecting fewer inventories and more imports, the Commerce Department's report showed. Revisions to GDP figures going back to 2003 showed that the 2007-2009 recession took a bigger bite out of the economy than previously estimated, and the recovery lost momentum throughout 2010. The world's largest economy shrank 5.1 percent from the fourth quarter of 2007 to the second quarter of 2009, compared with the previously reported 4.1 percent drop.
FLASHBACK to July 24th, 2009, "Out of Sight - Out of Mind: The Way The Markets Like It": "As the truth comes out later, who cares what happened in the past because the markets are forward-looking!" - do you ever wonder why we experience so many more downward revisions of past data than we do upward revisions of past data? Do you ever wonder why we tweaked the methodology of how we count unemployment and inflation? The answer is because the truth to past ways of measuring these things would scare the heck out of markets and economists. Crazy.

Right now, money is leaving risk assets and looking for safety in an environment ripe with uncertainty. Its all about perceived levels of uncertainty. Even if our government reaches a deal on the US debt ceiling, we can still lose our AAA rating and investors perception of our treasuries as uber safe securities, may wane. As of right now, thats not really happening outside of short term movements at the very short end of the curve (think 3-month and 6-month treasury securities) - look at the chart below to see how short end yields have risen in the past week:



What if equities, high yield bonds and treasury bonds all selloff at the same time? Is that even possible? Oh yes, I think it is. Where will money go for safety? The quick answer is gold. But the kicker may be a huge emergency plan by our Fed to implement QE3 that would surely be a massive treasury and asset security buying campaign to the tune of trillions in a last ditch effort to both keep rates low and stimulate the economy. That could be what makes gold go parabolic. I dont know, just a hunch looking at potential outcomes given our current situation. Lets see how markets react in coming weeks and what signals they are telling us.

For now, it looks like investors are pricing in for a future economic downturn, albeit not one anywhere as severe as the recession we experienced in 2008-2009. This could be the whiplash back down as a fed and govt induced reflation from huge stimulus and asset guarantees wanes. The party cant last forever when its juiced by artificial stimulus.