The below chart from SocGen demonstrates why the stock market, unlike bonds, is currently massively overpriced. The current economic surprise factor swing, from an all time record at +100 recently, down to about -100 (the third lowest in the past 5 years, and likely longer), a 200 point swing which only compares to the 2008-2009 Lehman collapse, was accompanied by just a 15% drop in stocks over the past 8 months, indicates two things: either the current "soft patch" is indeed "transitory" as the Fed would like us to believe, or that the market is pricing in QE 3. And while SocGen, which is the source of this chart, believes that the collapse is indeed "transitory" we completely fail to see what the factor will be that will push the global economy higher in Q3 and onward: Japan? Europe? Fiscal generosity in the US? China? No, no, no and no. Sorry, there is no catalyst that will provide an impetus for a hockey stick effect this time around. Except, of course, for more monetary easing, perhaps in Japan, but mostly in the US. Yet for that to happen, as we have been claiming for nearly half a year, stocks will need to plunge to their pre-QE2 levels, or about 900. Alas, the mutual funds which currently hold the lowest amount of cash in history, and are levered more than ever, are simply unable to sell without blowing themselves up. We are confident, more than ever, that an unstoppable desire for extend and pretend is about to hit an immovable force...
Slowdown driving yields lower, but double dip clearly not priced in. 10-year Treasury yields are back below 3.0%, as those – like us – who had a small bearish bias into the end of QE2 continue to be frustrated. There is little doubt that increased EMU have supported some flight-to-quality flows into Treasuries. The Greek 5-year CDS has widened by some 500bp over the past 2.5 months (a 50% increase). However, the prominent driver remains the economy, which has delivered sharp negative surprises over the past three months. The consistent and large positive US economic surprises at the turn of the year have reversed sharply. If anything, despite the help from EMU jitters and other signs of reversed exuberance (e.g. Chinese equity market at a 4-month low) 10-year Treasuries have struggled to keep pace with the poor data (Graph 1).
The Fed told us at the 27 April FOMC that the Q1 slowdown was transitory. Well, the transition has grown a bit long, with Q2 showing little bounce so far from the soft 1.8% growth seen in H1. Admittedly, we have seen more transitory negative forces at play; in particular the Japanese disaster has disrupted the global supply chain. Let’s make no mistake, however, the market has priced the slowdown as being a temporary phenomenon. Graph 1 suggests that yields might have fallen much more otherwise. Equally, the S&P has erased just 15% of the gains made in the eight months to late April. Global markets are clearly not pricing a double dip just yet. In a double-dip scenario, QE3 would be on the table, which would feed the Treasury rally.
Our economists certainly are in the ‘transitory slowdown’ camp and are looking for a bounce in Q3. Sentiment should start to improve by mid-June, when the first manufacturing reports for this month are due. This improvement in sentiment would coincide with the end of QE2 by late June, adding pressure on Treasuries.
In the meantime the pain trade is for Treasury prices to crawl higher as the TYU1 closes the gap to 124-02 (see technical analysis section). There is little data to turn sentiment in the coming week, once the NFP report is out of the way. The 3-, 10- and 30-year Notes need to be digested though. Note that the PBoC may deliver another rate hike ahead of the June 6 holiday as it fights inflation (our economists predict a hike this month), and this could add to global growth concerns.