Are Bond Yields Trying to Tell Investors Something?

The latest concern on the tips of investors tongues is: what, if anything, are falling bond yields trying

to tell the market? The concern is legitimate, as falling interest rates typically precede a recession, and with the major stock indexes flirting with historic highs, a correction could be in the offing. Are investor's concerns justified? Depending on who you listen to, investors may or may not need to worry.

Why Are Yields Falling?

The only reason falling rates is raising a red flag, in the first place, is that it does not jibe with a recovering and growing economy. Falling yields, or rates, are typically associated with a poor economic outlook. As an economy strengthens, and its outlook improves, long term interest rates typically rise as inflation becomes a concern. The fear of inflation is associated with falling bond prices as yields rise. Investors anticipate Fed intervention to cool a overheating economy which leads to rising yields. It's a self-fulfilling prophecy: investors expect the Fed to raise rates so they beat them to the punch and start to sell bonds. The logic and disposition of investors when the opposite is true is that something must be wrong with the economy when yields are doing the opposite. It is a justifiable concern. The reality is that although money manager insist that the economy is on the mend, the data doesn't support this position.

Economic Data

After heating up, real estate seems to be faltering, despite higher than anticipated housing starts on Friday. Most other metrics are not as robust. Another housing market concern: weakening demand. Fewer young folks are seeking homeownership, nor can they afford it. In addition to real estate, the consumer is another concern. The anticipated rebound on retail sales has not materialized as some had predicted. One suspect to look at for a weak consumer is prices at the pump. There is no way around $4 a gallon at the pump. Consumers have to fill their tanks to get to work and that eats in to discretionary income, and therefore less spending on other items.

The Fed

Economic data aside, the Fed is still in play regarding asset purchases. It may be purchasing less but it is still buying upwards of $40 billion in bonds each month. That's a lot of assets. So, there is still downward pressure on yields, from the Fed alone. The fall in yields has been associated with a bump in mortgage refinance applications as reported by the MBA. This is a desired result of the Fed as it eases stress on the consumer.

Is Something Else at Play in The Market?

The famously ebullient Jim Cramer, of CNBC's Mad Money fame, offers another option as to why yields are rising: an investor mentality paradigm shift. The host of Mad Money may be on to something. After two significant market declines, investor's timidity is understandable. The retail investor just has not embraced this bull market, in fact, has resisted this market recovery, viewing the disconnect between Wall Street and Main Street as their main concern. Are investors favoring the security of US treasuries over equities more now than in the past? An argument could be made that, in fact, they are, despite historically low yields. The mentality being: a little gain is better than a big loss. An interesting observation this year versus last year: all the talk of a "Great Rotation" last year is completely absent from todays news stream and headlines. Is there even such a thing as a rotation to even consider it as a possibility? Some analysts say it was never an option. What is interesting this year, however, is that no one is suggesting one. This could mean different things, but it, at the least, suggests investors are not anticipating large sales of fixed income securities.

What Does it All Mean?

The real concern might be the divergence that is occurring in the equity markets in addition to falling bond yields. High tech, high momentum, small cap stocks are skidding while investors are seeking the safety of large caps, thus we see historical highs in the Dow and S&P 500. Also, when large players, like David Tepper, start suggesting caution, it warrants attention. Is it time to take some money off the table? Maybe "sell in May and walk away" is justified this year.