Much lower Treasury yields and stock prices will follow the double dip threat

The outlook is for a further sharp decline in Treasury yields and stock prices. But that is far from the consensus forecast.

Despite the recent declines in both US Treasury yields and equity prices, the majority of forcasters are still calling for significantly higher Treasury yields and equity prices. That disparity in viewpoint in large part reflects the difference in what forecasters are focusing on. The optimists expecting yields and stock prices to rise are emphasizing the economic recovery and an array of other seemingly positive yield and equity price boosting forces. These include the presumed inflationary huge Federal budget deficit, the Fed's extended stimulative monetary policy, the potential for higher oil and sea food prices due to the Gulf oil spill, and the already extraordinarily low level of interest rates. Also, seemingly persausive to many analysts is the rise in corporate profits and projections of still higher levels of profits next year. That will lower price-earnings levels to below historic averages, which to many seems a fool-proof assurance of higher equity prices. Given these and other wide ranging considerations that seemingly support their view, it is difficult for many analysts to recognize that instead it is far more likely that Treasury yields and stock prices will decline. Lets explore some of the contrary reasons that to this observer seem far more compelling that economic weakness and a deflation threat will force yields and equity prices down to significanly lower levels.

The financial meltdown was a reflection of a huge overleveraging and debt explosion accross virually every sector of the US and global economy. The economic contraction and deleveraging that followed was arrested and reversed only temporarily by a huge stimulus, Federal bailout and change in accounting practices that delayed the day of reckoning. The losses involved have not been fully recognized or written down against capital. Now the effects of the economic stimulus are beginning to run their course. That is already evident in housing. The result is a pronounced double dip in the housing sector that is already evident and likely to persist. Employment was appreciably boosted by census employment which will disappear in the next employment report. There will be an increasing recognition that the unemployment rate will remain high for years to come. That will, in turn, constrain consumer spending. But, that view runs counter to the reality that the consumer sector has been more resilient than a persistantly high unemployment rate would warrant. Unfortunately, the partial explanation is that far too many home owners with an outstanding mortgage balance that exceeds the market value of their home have decided not too make their mortgage payments. That has allowed them to maintain their life style. But that source of consumer spending will not persist as a new wave of foreclosures forces consumer spending retrenchment and new downward pressure in home prices in affected areas.

The adverse consequences of the Gulf oil spill and moritorium on deep water drilling is an additional negative for the US economy. The new financial regulation legislation, though less onerous than feared, will still crimp financial earnings and already contrained lending.

State and local governments are running huge deficits and will be forced by law to cut spending and/or raise taxes, which will appreciably curtail economic growth.and their credit worthiness.

The global economic recovery is bound to slow with the eroding pace of US GDP growth, constaints on European credit and economic growth stemming from the fiscal austerity imposed in response to the European credit crisis and China's efforts to puncture both its housing bubble and inflated growth pace. That combination, and the stronger dollar, will slow US export demand and with it, US growth.

The Federal credit expansion is not inflationary because it is only offsetting a contraction of private and other public credit. Banks are still reluctant to lend.But there is likely to be a new contraction of credit in the wake of the credit crisis abroad and state and local finance problems.

These and other economic and credit market contraints will keep inflation surpressed and deflation fears alive. That will maintain the 10-year Treasury yield downtrend to well below 3.0% later this year and next from the 3.11% on Friday. A 2.5% or lower 10-year yield is even possible later this year and quite likely next year. That will drive the yields on the best corporate and municipal credits comensurately lower as well. However, the quality yield spread on lesser credits will likely rise significantly, reflecting the renewed increase in both default risk and realty.

A downtrend in equity prices is also in place and is likely to be extended amidst disappointment with corporate earnings and economic prospects. The equity market will remain in a secular downtrend. What we have experienced since March last year has has been nothing more than a bear market rally. Just because the current price-earnings ratio is slightly below the long run average of 15 offers no protection against a further sharp decline in equity prices. Indeed, there has been a long-term cylical pattern of the price-earnings ratio. Historically, after the price-earnings ratio has topped out at or above 20-plus, as it has with a vengence at its most recent high, the ratio has then usually trended down over years to well into the single digits. That pattern is likely to be repeated. In that case, it goes without saying that investers will be far safer to be short than long.


Philip Braverman, President
Braverman Financial and Economic Consulting
One Hewitt Square #249
East Northport, New York 11731

This and prior reports can be accessed by going to Internet explorer and typing inthe following: philipbraverman.blogspot.com

I can be reached at philipbraverman@gmail.com