Main Street: What Low Bond Yields Reveal About The Economy

Source: Main Street

Author: Scott Gamm

Yields on government bonds continue to slide, as investor jitters about the economy worsen.

Rates on 10-year Treasuries, which determine the interest rates that consumers care about, such as mortgages and car loans, stand at 2.46%, down from 3.00% on January 2, 2014.

Yields are on the decline as investors buy up Treasuries, considered safe-haven assets when equities and other investments look too volatile. Demand for government bonds pushes up prices. Bond yields and prices move inversely.

Increased investor appetite for Treasuries speaks volumes about the state of the economy.

"The bond market is always smarter than the equity market," says Scott Carter, CEO of Lear Capital. "The bond market is telling us that the economy is slowing, the stock market will correct and despite its pathetic yield, bonds are the better place to be."

As bond yields fall, the stock market is still at record highs, shedding light on the conundrum in the markets. The broad S&P 500 hit yet another record on Thursday, ending the trading day at 1,920.03. The Dow Jones Industrial Average is also hovering near its May 13 record high of 16,715.44.

"Bond yields and stocks move in tandem and they're not right now," Carter adds. "You have early signs that equities are due for a major correction."

The drop in bond yields is taking place amid the Federal Reserve's scale back of its bond stimulus by $10 billion per month, which is expected to continue until October. The Fed's stimulus, also known as quantitative easing, has flooded the markets with liquidity over the past few years and has kept interest rates low.

"With the Fed's tapering, I would have expected the 10-year yield to rise, reflecting economic strength," Cater tells MainStreet. "The opposite is occurring because you're seeing vulnerability in virtually every major economy."

In the U.S on Thursday, the first quarter GDP was released by the Bureau of Economic Analysis and fell by an annualized 1%, compared to a 2.6% gain in the fourth quarter of 2013. On Friday, the Commerce Department reported consumer spending fell 0.1%, while personal income rose 0.3% in April.

Adding to the bond rally is the expectation that key interest rates in Europe will be cut at the June 5 European Central Bank meeting. Europe has been struggling with paltry inflation of 0.3%, which is well below the central bank's target of just under 2%. In fact, fears of deflation in Europe are growing. ECB President Mario Draghi hinted that a rate cut could happen during the June meeting. A rate cut would bolster investors' confidence of the bond market, leading to even more downward pressure on yields.

In Germany, the number of unemployed rose by 24,000, leaving investors perplexed. "Expectations were that the unemployed would drop by 15,000, so this makes investors think the economy won't recover as soon as expected," says Kevin Horan director of fixed income indices at S&P Dow Jones Indices.