Danger: Low yields ahead

The bond market has rallied lately, pushing long-term interest rates lower. That could be a sign that economic recovery hopes are fading. Or not.

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By Paul R. La Monica, CNNMoney.com editor at large

When will you know that an economic recovery is underway?
  • When the Dow tops 10,000
  • When GDP turns positive
  • When job growth resumes
  • It's already started

NEW YORK (CNNMoney.com) -- Stocks took a beating Thursday and didn't recover much Friday following the news that the job market took another turn for the worse in September.

Some experts argue that the pullback is not really due to renewed fears of impending doom for the economy. Instead, it may be nothing more than a long-awaited, healthy correction following the stock markets almost seven-month long surge.

That may be true. But if you look at what's happening in the bond markets lately, there is definitely cause for concern.

Long-term Treasurys have actually been rallying for months, pushing their yields lower. (Bond prices and yields move in opposite directions.)

Two weeks ago, the yield on the benchmark 10-year Treasury stood at about 3.5%. But it slipped to around 3.2% Thursday and was down to 3.17% on Friday morning after the release of the jobs numbers.

The yield on the 10-year is now at its lowest level since mid-May. Rates on the 30-year Treasury have also fallen sharply in the past few months.

This is important -- and potentially worrisome. When investors are buying bonds, it's usually because they are worried about an economic slowdown.

"Bond investors have been ahead of the stock market. Recent data shows a softening of the economy at the end of the third quarter as we head into the fourth quarter," said Andrew Busch, chief FX strategist with BMO Capital Markets in Chicago.

As a result, the recent rally in bonds could be a proverbial flight to quality. Investors tend to flock to less risky assets in times of uncertainty and confusion. And despite the many financial problems that America as a nation faces, debt that's backed by the U.S. government is still considered to be about as safe as you can get.

So it may seem somewhat counterintuitive, but the lower the yield on long-term Treasurys, the worse it probably is for the economy -- even though investors in U.S. debt fully expect to get paid back.

To put that in perspective, rates on the 10-year fell as low as about 2% back at the height of the financial panic in late December.

Yields are hopefully not going to fall that low again. But Bruce McCain, chief investment strategist with Key Private Bank in Cleveland, said that is only natural for investors to be somewhat skeptical of the stock market and consider buying more bonds.

"We've not reached the tipping point where many investors are willing to take risks with stocks. That is supporting the bond market," he said. "Bond funds are where a lot of people are putting their money. And with renewed or reinforced concerns about the economy, it would not be overly surprising to see a further rise in bond prices."

The reverse was the case as the stock market started to rally this spring and investors seemed to grow less worried that the recession would morph into a full-blown depression. Bond prices fell and their rates rose. The yield hit a year-to-date high of about 4% in June.

Normally, higher long-term rates are associated with inflation fears. And that makes the dip in long-term rates back toward 3% all the more puzzling.

The fact that long-term rates are now as low as they are seems to indicate that the bond market isn't worried about inflation after all. Yet, some inflation hawks have been squawking loudly about the potential for nasty price increases down the road.

In particular, there are growing concerns that all the money being spent by the government to try and stimulate the economy out of recession will ultimately come back to haunt us in the form of inflation.

And outside of the bond market, there are some classic inflation warning signs. The dollar has weakened against the euro and a basket of other currencies in recent months. That's helped lead gold prices above $1,000 an ounce.

The prices of oil, sugar and copper have shot higher as well -- and investors often dive into gold and other commodities as a hedge against inflation.

So what gives? Busch said that inflation fears are legitimate.

After all, the Federal Reserve left interest rates near zero following its latest policy meeting last week and has only given slight hints about when it will start raising rates and unwinding various liquidity initiatives. But Busch added that it's too early to be fretting about inflation now.

"This is all about the time frame. In the immediate term, the concerns are about deflation. But the Federal Reserve is pumping a lot of money into the system and that is never a good thing for inflation in the long term," he said. "Commodity prices are higher than one would expect given where bond yields are. But three years hence from now we could have really ugly inflation."

Deflation, the economic condition in which the persistent decline in prices leads to a pullback in production, rising unemployment and even lower wages, is obviously a big concern.

And the September jobs numbers show that we're not out of the deflation woods yet. Average hourly wages rose only slightly last month, but because the length of the work week was shorter, the average paycheck actually shrunk.

Still, McCain said investors shouldn't rush to declare that the economy is now dead in its tracks because of the bad jobs report.

"There are concerns about the recovery, but whether they are legitimate is debatable," said McCain. "The job results were disappointing and it's obviously a setback. But this is typical for recoveries .You don't always have a continuous move up."

To that end, a decline in long-term bond rates could actually help get the economy back on track if it is able to provide a lift to the long-suffering housing market.

Mortgage rates have edged lower lately and that trend could continue as long as long-term Treasury yields slip. Of course, banks have still been reluctant to lend so it's not certain if lower rates will have that much of an impact.

And at the end of the day, bond rates can only fall so much. If the yield on the 10-year dips below 3% once again, that might be more alarming than comforting.

"Lower rates are a modest positive, but they are too low given the current environment," said Tom Higgins, chief economist with Payden & Rygel, a Los Angeles-based money management firm. "There was a gradual move upward in yields this spring and that maybe went too far. But yields will have to move higher again."

Talkback: Inflation? Deflation? Jobless recovery? What do you think is the biggest risk for the economy? Share your comments below. To top of page

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