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Did the Stock Market Misread the Bond Market?

A trader at the New York Stock Exchange.
Photo: Oliver Quillia for CNBC.com
A trader at the New York Stock Exchange.

Tuesday’s stock sell-off was just a misunderstanding, Cumberland Advisors’ David Kotok tells Politico’s Morning Money.

Kotok argues that yesterday’s dramatic surge in Treasurys was not a flight to quality signaling fear of economic troubles. It was just short-covering following the news of a debt ceiling dealing that took the possibility of a default off the table.

But equity markets misread the bond tape as indicating that we’re hurtling back toward a recession, Kotok argues.

From Morning Money:

“You’ve had a series of statistics that have been ugly and sentiment was damaged by the debt ceiling debate. ... But in the end the system worked. The outcome was no default when at some point the risk of one seemed 50/50. ... And then you had a monster rally in Treasurys because there was no default. ... There were HUGE SHORT POSITIONS worldwide in Treasury notes and bonds established through derivatives and you had a short-covering rally. The robustness of it tells you how big the short was. ...

“The equity market MISUNDERSTOOD THIS as a flight-to-safety, which makes no sense. How do you have a flight-to-safety if your credit rating is still under attack? ... We had a supply chain shock from Japan that was very substantial and impacted manufacturing world-wide.

We have now seen the worst of it and it is being cured every day. ...

“The recovery will start to reappear in (the third quarter) and more strongly in (the fourth quarter), which could see growth of 3 percent or more. It will be rocky for a while but we are coming back from a deep hole. The market is discounting a return to recession that SIMPLY IS NOT COMING.”

I’m not persuaded. I do not think that bond traders ever really believed that there was a realistic possibility of default. What’s more, I don’t think it’s irrational for investors to buy Treasurys when the news cycle is dominated by the possibility of a downgrade of the U.S.’s credit rating. In fact, I expect that Treasurys would probably rally if the U.S. was downgraded.

Why would downgraded bonds rally? In part because of the relative nature of financial assets. Weakness in the credit quality of the U.S. government would trickle down through nearly every sector of the economy. Anything that the government buys, explicitly guarantees, implicitly backstops, subsidizes, or awards preferential tax treatment—which, at this point is everything except cigarettes and porn—would be hurt. Internationally, it’s hard to see any other debt issuer that can provide the liquidity, safety and volume necessary to replace U.S. debt as a "risk free" buy. On a relative basis, Treasurys would still be the safest thing around.

Of course, I’ve got a far more pessimistic view of the likely economic scenario for the rest of the year than Kotok. I’m nowhere near as confident that a return to recession is off the table. The American consumer is still in a deleveraging mood—and any economic slowdown will only prolong that condition. In fact, a recession this year or next seems to me a very real possibility—especially given the haplessness of our elected officials and hopelessness of many of our corporate leaders.

So I find Cullen Roche’s explanation far more plausible:

"The bond market was never worried about U.S. default or the end of (the second round of quantitative easing) because that’s not what the bond market takes its cues from. The bond takes its cues from the (Federal Reserve) . And the Fed takes its cues from the economy. The simple message coming from the debt ceiling debacle has not been one of insolvency. Only the media and the fearmongerers were focused on an actual insolvency. The real story here was always the impact of the debt ceiling outcome on the real economy. And the bond market’s message has been loud and clear. Bond traders think this deal stinks for the economy and what they see is an anemic economy. It’s that simple."

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