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Bonds Gain Edge Over Equities in Economic Debate

Bond investors are looking more and more on the money than stock investors these days after poor economic data sent the 2-year Treasury yield to a record low and the Dow Jones Industrial Average plunging by as much as 200 points.

Before this summer swoon, many investors scratched their heads as stocks rose, while bond yields continued to fall. The natural relationship is for the two to move in tandem as higher economic growth and inflation lifts stock prices and at the same time, hurts bond prices and sends yields higher.

This conundrum has puzzled market participants, most famously former Federal Reserve Chairman Alan Greenspan in 2005, a few times over the years. Most of the time, according to Citigroup Global Markets, equities are proven to be right as the economy recovers and yields are forced higher. But are they this time?

Data today showed weekly jobless claims at their highest level since November and that a measure of manufacturing activity in the Philadelphia-area unexpectedly shrank. This is not the kind of activity that an S&P 500 up 7 percent from its 2010 low (before Thursday) was predicting.

“The bond market is telling you the economy is worse off than people think,” said Guy Adami, Drakon Capital managing director and a ‘Fast Money’ trader. “People argue about a double-dip, but I would argue we never got out of the recession.”

If bonds are right, it would be a break from history. “Of the eight previous episodes where bond yields have fallen, but equities have rallied (like now), we have found the equity market was ‘right’ on five occasions,” said Citigroup’s Robert Buckland, in a note. “After each it was bond yields that rose to catch up with stock prices rather than vice versa.”

There was one case, in 2004, where it wasn’t entirely clear which asset class was right, according to Citigroup.

“This time, we expect the conundrum to be resolved through rising bond yields,” said Buckland. A “sustained global economic recovery and gloomy fiscal outlook should push yields up from their current historically low levels.”

The other option is that that both asset classes are wrong.

“This time Treasuries are not about inflation or deflation,” said Brian Kelly, founder of the aptly named Kanundrum Capital. “They are about capital preservation as baby boomers approaching retirement want to protect what is left of their nest egg.”

It’s still a close call, but today’s data argues that it’s equities that are behind the curve, the yield curve that is.

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