Bonds and stocks diverge on U.S. economy
September 9, 2009: Excepted from Market Watch and decision economics.

For those investors who believe the stock market works perfectly at discounting risks and rewards, the U.S. economy and corporate profits must seem to be on track for a stellar recovery. After a spectacular 50% surge since March, stocks on the S&P 500 Index ($SPX) have continued rising through the summer and into September. Since returning from the labor day holidays, U.S. stocks continued to advance after the Federal Reserve's Beige Book of current economic conditions. The central bank said the economy is improving across most U.S. regions but that consumer spending remains sluggish.

Yet, the market for U.S. government bonds, considered among the safest assets around, seems to be telling a different story."There is a growing group of people following the view that we'll have a jobless recovery in the economy," said Bill O'Donnell, head of Treasury strategy at RBS Securities. "They're asking what comes after the sugar-high from the government stimulus measures, and what they see is rising joblessness, consumers spending less and lower inflation. All in all, good conditions for bonds."

Separately, Treasuries turned higher after the Beige Book and after the government's auction of $20 billion worth of 10-year notes was met by ample demand. Demand for benchmark 10-year Treasury notes surged over the past month, sending their yields (UST10Y) down by about 40 basis points. Bond yields move inversely to price.

The visible hand of government

"The government has got a heavy hand in this recovery," says Jack Ablin, chief investment officer at Harris Private BankAblin does believe the economy and stocks are still running on the "sugar high" provided by government spending. However, while the bond market may be looking further ahead when the economy might run out of momentum next year, he doesn't believe stocks have to come down.

"There's still 10 donuts in the box [out of 12]," Ablin says. "We've only spent about 10% of the $800 billion or so committed. "The government is still spending a lot of money and that's going to be reflected in the economy and profits at least for the next couple of quarters."

And corporate bonds also continue to improve steadily, he noted. Meanwhile, government bonds may simply have become a good bet again because of the lack of inflation in the outlook for the economy.

With the government raising close to $2 trillion to help shore up the economy, and as markets took the view back in March that those measures had helped avoid the worst, Treasurys seemed to be a bad bet for most of the year, and yields surged along with stocks. Some of the hesitations on the way up were that government spending would pressure the dollar and boost inflation, and that raising money might become harder as buyers of U.S. debt, including foreigners, would become more scarce.

But while the dollar has returned to its lows of the year, few believe inflation is in the cards as long as the economy continues shedding jobs, and consumer spending, which makes up for about 70% of the economy, remains muted. And judging by the results of this year's auctions, demand for U.S. government bonds remains strong.