Stagflation confusing Fed and the bond market – where will long bond yields go?
Gloria Howard
Oct. 15, 2006

The bond market players are confused. They never saw anything like this. The Fed is actually more confused. Some indicators say economy is strong. Some indicators are absolutely clear about the weakness in the economy. The commodity prices point towards inflation but staggering underemployment show massive hidden deflation.

When yields on ten year notes reached 5.2% and the Fed was relentless in raising rates, the market smiled and gave one of the finest rally in long bond market. Yields collapsed to 4.5%. Even the bond gurus got trapped in it and very few could take advantage of the same.

Economy is plagued with stagflation. The stagnation component is more prominent now with little pricing power for corporations that depended heavily is cost cutting to improve the bottom line. The CRB index is correcting after going through the roof. The inflation component is coming down while the economy slacks.

Something interesting is happening in the leading indicators and capacity utilization data to be released this week. The capacity utilization will moderate somewhat but surprisingly the leading indicator will rise sharply. That will show the economy on the long term may be stagnating but there are spots of strength and more importantly the economy is actually very strong between now and the next six months. The fabulous stock market rally shows that clearly. That means bond market can actually test the high yields of 5.2% again. At that point, the economy will start showing weakness and possibly the stagflation will change to outright deflation. Bonds will from that point for many years. In 2008, there is good possibilities that we will see Fed funds rate close to 1% or lower – just like Japan where rates went and stayed at 0% for quite some time.

Stagflation confusing Fed and the bond market – where will long bond yields go?
Gloria Howard
The bond market players are confused. They never saw anything like this. The Fed is actually more confused. Some indicators say economy is strong. Some indicators are absolutely clear about the weakness in the economy.
READ MORE>>

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A slightly lower Capacity Utilization will further show lower inflation pressures but a long term topping action is sending scary signals
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