June 28: The Bond Market Conundrum – Economic Highlights

Yields on treasury bonds were expected to start trending up as the end point for the Fed’s $600 billion QE2 program came closer. The thinking was that as the Fed stopped buying these bonds, yields will have nowhere to go, but up. This fairly plausible view, which has Pimco’s Bill Gross as one of its exponents, has failed to materialize thus far.

With QE2 just days away from coming to a close, yields on the benchmark 10-year treasury bond are below 2.9%. Yields on the shorter maturity treasury bills are close to zero. This would mean that investors in treasury bills are not asking for anything in return for lending money to Uncle Sam. Given the deadlocked debt-ceiling negotiations in DC and Greece’s debt problems hogging headlines, is the bond market behaving rationally?

The short answer is – Yes. The bond market is rationally pricing what the Fed will do to its balance sheet and short term interest rates even as QE2 ends. But the biggest contributor to low bond yields is the same factor that has been weighing on stock prices as well, which is the recent run of soft economic reports. The stock and bond markets are trying to size up whether the economic softness is a result of temporary forces or something that will carry over into the second half of the year. The ISM Manufacturing report coming out this Friday and the non-farm payroll report coming out next Friday will provide more near-term clarity on the growth front.

Heightened global uncertainties resulting from the Greece debt crisis also increase the allure of U.S. treasury bonds given their safe-heaven status. The Greek parliament will be holding a crucial vote on a new set of much more tougher austerity measures later this week. A positive vote will pave the way for a new EU/IMF rescue fund. Given last week’s successful vote of confidence for the cabinet, the odds of getting the parliament’s approval appear quite high. We will know for sure only after the vote take place, but even a successful vote will hardly be the end of the Greece story.

In Corporate news, Nike (NKE) reported better than expected results after the close on Monday. And Accenture (ACN), the consulting firm, is getting added to the S&P 500 Index next week. Accenture will replace Milwaukee-based Marshall & llseley (MI), whose acquisition by Bank of Montreal (BMO) is expected to close next week.

The markets are effectively in a wait-and-see mode at present, a trend that is likely to remain in place till visibility on the domestic growth front improves. The coming ISM and labor market reports will provide useful clues to how the economic picture will unfold.

Consumer Confidence figures are expected today at 10:00 AM. The index had decreased to 60.8 in May from 66.0 in April. The Present Situation Index decreased to 39.3 and the Expectations Index declined to 75.2.