10 Yr Treasury Shows Nominal GDP is Under 3%

Dr Ed Yardeni comments on the dynamics of bond market pricing in his post titled "The Bond Yield". He makes the point that bond yields and the expected nominal GDP rate have a lot in common. Yields tend to revert to the expected nominal GDP rate.

GDP is a measure of the output of goods and services produced by labor and property located in the United States. It is also an indicator of broad US based economic activity that is expected to be reflected in the stock market.

The article focuses on 'expected' rather than 'stated' GDP rate. According to John Williams at Shadow Government Stats, "GDP reporting remains the least meaningful and most heavily gimmicked/politicized of the major economic series, at least in the first year or so of reporting."

Expectations for GDP are useful to provide hints about the near term trend of consumer confidence and stock market sentiment. It is fuel for the bulls and the bears, depending on their bond yield expectation.

Economic Condition Review 1Q2011

Looking back on the end of 1Q2011, the world is still reeling from the tsunami and earthquake damage in northern Japan, and traces of radiation turning up in unwanted places like certain food and drinking water sources and in ocean water along the plants. In northern Africa, the civil revolt in Egypt has resulted in the departure of the 4 decades long dictatorship of Hosni Mubarek leaving a power vacuum which will be resolved later, hopefully with a democratically run election. Next door to Egypt, the dictator of Libya is fighting his own countrymen who want him, Muammar Gadhafi, to give up his dictatorship. Other uprisings are beginning to build in several other oil producing countries in the region, including the Arabian peninsula. The threat of crude oil shipments being interrupted is a big concern for all countries importing from this region and is the reason for the multi-lateral military action intensifying now, particularly targeting Libya.

In Europe, the government of Portugal has collapsed. The government voted to not accept more austerity measures which was recommended by the former prime minister and his finance minister. This development is expected to lead to a bailout of the country's sovereign external debt by the European Central Bank and/or the IMF. The financial conditions attached to bailouts have been painful so far for Greece and Ireland. Both of those governments are debating how to incorporate the painful bailout conditions or to default on them. Default is immediately easier and politically popular in the countries. China is concerned with internal high and climbing food and shelter inflation threatening the massive lower classes, potentially destabilizing the power of the ruling party. Published reports claim that interest rate increases are on the calendar in China now to slow lending and personal discretionary consumption.

In the US, the Treasury market is finding some strength on a risk-off move recently. The US$ is weak, currently near the 76 mark. New and existing house sales numbers were reported recently by the Commerce Department and are lower than projections. Nationally, median house prices are now at December 2003 levels. Banks, the primary source of credit for economic expansion, both consumer and commercial borrowers, are lending only to prime customers, letting growth of credit remain below trend. Bank closings totalled 11 in January, 12 in February and 3 through March 25, according to the FDIC. Most businesses do not have pricing power, so prices are holding the line so far despite rising commodity prices. Exceptions are businesses with pricing power such as universities, health care services, food and energy producers. Inflation (see Q4 CPI) for gasoline in 2010 came in at 13.8%, the overall energy component at 7.7%, and in the major grocery store food groups, the index for meats, poultry, fish and eggs posted the largest increase at 5.5 percent.

The Federal Reserve is pulling the strings to guide global perception about the strength of the US$. The Fed has no choice but to continue it's zero interest rate policy and money printing practice. They will attempt to support the Treasury market when the primary dealers and global participants back away more than they have now. How the Fed uses it's power may look different and they will call it by another name to put watchers off the scent. But we are talking about a global economy here. Not just the US. Other major economies are directly impacted by the Fed's actions. So they become partners in the deed and will cooperate to the greatest possible extent. This will buy time. The possible time frames are wide ranging from many months to years. Unforeseen events, natural and physical, with financial consequences are wild cards that can, of course, shorten the time frame by changing the delicate balance in place now.

Economic Condition Review 4Q 2010

As 2010 ended, the wait began for Q4 corporate earnings reporting season. Expected are confirmation of the health of the US consumer and corporate guidance leading to confirmation of an economic recovery that is sustainable. Commercial balance sheets are doing everything possible to restore financial health, including cutting expenses by laying off workers and paying off debt. Banks, the primary source of credit for econimci expansion, both consumer and commercial borrowers, are lending only to prime customers, letting growth of credit remain below trend. Most businesses do not have pricing power, so prices are holding the line so far despite rising commodity prices. Exceptions are businesses with pricing power such as health care, food and energy. Inflation (see Q4 CPI) for gasoline in 2010 came in at 13.8%, the overall energy component at 7.7%, and in the major grocery store food groups, the index for meats, poultry, fish and eggs posted the largest increase at 5.5 percent.

During Q4 2010 the Fed implemented the follow-on to quantitative easing we call QE2. This liquidity program is ultimately responsible for accomplishing one of what has become three objectives (maintain price stability, maintain full employment, and now support reflation of US stock market indexes). Obviously the one objective the Fed is succeeding at is reflation of the stock markets. So far, the Fed is not being successful at their two primary objectives. Now a big question is how can US stocks maintain their advance without the rest of the world's participation. Hello Ben. An answer please.

Why bond mutual funds?

I have reported that bond mutual funds have been getting the majority of new dollars from fund investors, according to Strategic Insights. So what are the expectations from a portfolio of corporate bonds. Here are a couple of charts from the St Louis Federal Reserve illustrating current yields on two types of bonds, high quality (Moody's AAA) and medium quality (Moody's BAA).

Click on graph for a larger image

As you know, bond yields and prices move in opposite directions to each other. So as yields have come down, prices have moved up. And many would say that the opportunity for big double digit returns from bond funds, as we have recently enjoyed, is a once in a lifetime opportunity. These graphs seem to illustrate that too. As you can see, yields have dropped to near recent historic low levels, not leaving much hope for still lower yields and higher prices. In this environment, mutual funds that use a buy and hold strategy can expect no more than the coupon (dividends). On the other hand, funds that employ trading strategies to take advantage of apparent mispricing could add to the total return of the fund. Scanner