10-Year Treasuries Yield Their Lowest in 11 Months

The S&P 500 Index closed at 1909.78, -2.13 points or -0.11%, after struggling to hold onto gains late in the session. The index is higher by 3.32% on the year. The bigger story today is the 10-year Treasury yield, which closed at 2.438%; its lowest level in over 11 months. Bond yields and prices have an inverse relationship (i.e. as yields fall, prices rise).

It is commonly thought that equity markets and fixed income markets should move in opposite directions. As such, many are suggesting that Treasury yields are indicating a forthcoming equity market correction. Sometimes, this relationship is true. However, U.S. financial markets are currently distorted by the ongoing purchases of the FOMC known as QE3.

There are two dynamics to consider when thinking about yields: Level and Trend. Lower yields (e.g. Level), as opposed to higher yields, are stimulative to the economy; primarily because they will generate increased loan demand (all else being equal). Higher yields–again, all else being equal–will reduce that loan demand. Falling rates (e.g. Trend), on the other hand, are an indication that there is not (yet) enough demand in the system. In other words, growth is slowing and/or expected to slow.

The Bureau of Economic Analysis will release its second estimate of Q1 GDP on Thursday, May 29. The BEA previously estimated that the U.S. economy grew at 0.1% in the first quarter of this year–a palty growth statistic for which analyst estimates were far too high. The consensus has since revised its estimate of Q1 GDP to -0.7%, indicating the economy contracted in Q1 2014. Their estimates for Q2 2014 GDP are once again nearing 3.0%, but those estimates are also likely to be too high. The BEA will release its advance estimate of Q2 growth on July 30th.

The big picture is that the U.S. is still in a deleveraging process and stimulative measures by the Federal Reserve are not effective on a permanent basis. And five-plus years of a near-zero Fed Funds rate and multiple rounds of quantitative easing nearly fits that “permanent basis” definition. These measures have not generated the economic growth of the mid-2000s. Instead, these measures created a scenario in which investors and businesses seek out other avenues to invest capital: equity markets. We are once again faced with an equity market that is dislocating from the underlying economy, but low interest rates will only contribute to this perverse feedback loop.

The conclusion is that equity markets will be constrained to the upside because of the weak underlying economic conditions, but bolstered by the Fed’s easy money policies. Investors should expect equity markets to continue to plateau.

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