Double Dip Recession or Not? Maybe the Bond Market Knows

By Pacifica Partners

Looking back at the start of this year, the markets began the year with good cheer and likely a fair dollop of complacency. Fast forward to the second quarter, and all of a sudden the PIIGS group of countries, double dip recession, and stubbornly high unemployment began to gain investor attention.

As has been commented upon in this space before, the bond market tends to be a better prognosticator of the economy's direction than the equity markets - most of the time. In general, rising bond yields have correlated with rising equity markets and falling bond yields (i.e. falling interest rates) come about as economic uncertainty gives rise to fear and panic.

So much effort is often expended on trying to predict market direction or how much the economy will grow (often turning out to be a fruitless endeavor) that all too often the obvious is missed. From our perspective, we have been keeping a keen eye on the 10 year Treasury yield (i.e. the level of interest investors are "charging" to be lenders to the US Treasury).

Even the 2 Year Treasury yield has come down to record lows as the bond market begins to price in an economic slowdown and the potential for deflation to set it in. At this point, perhaps it is too much too soon. Markets (including bond yields) never go up or down in a straight line. But since April, our line in the sand was drawn as we watched investors run for the safety of the bond market. This line in the sand was drawn at the 3.10% level. As we can see from the chart above, the line in the sand has been breached.

At these levels, the bond market has discounted little fear of inflation. The gold bugs have been pounding the table for years about the coming inflationary crisis that will be fueled by the printing of money by the world's central banks.

From the most recent data from the US Federal Reserve and the European Central Bank (ECB) it would seem that all of the monetary grease that they have put into the economy is not making its way into the economy - and this will be the case so long as the banking system globally is not running at optimal efficiency.

It is hard to argue inflation when US GDP numbers are being revised lower (not higher) for the last two quarters, Europe is undergoing spending cuts and tax increases, and even the Canadian economy has seemingly hit a rough patch for the month of April - surprising many an economist. Yet if they would bother to pay attention to the bond market (above chart), an economic deceleration has been slowly getting priced in.

However, that slowdown scenario does not presage yet another recession or double dip. A double dip recession is an infrequent occurrence - happening only once since the Great Depression. However, for many individuals looking to recover from the last recession or to get back into the labor force, the words "double dip" or "economic slowdown" are just semantics - the impact is real.

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