These are curious days indeed. On the one hand the weaker dollar is helping to reinvigorate the Asian growth trend and commodity sectors while on the other hand falling interest rates appear to be arguing in favor of rapidly slowing growth. Only time will tell which message will prove to be ‘right’.

Our thought today has to do with falling yields. Does it matter where the money is coming from that is contributing to lower interest rates?

To explain... if Treasury prices are rising because money is fleeing risk then quite obviously a strong bond market is a reflection of a weaker equity market. Fair enough. What if, however, the liquidity pushing Treasury prices upwards is coming from ‘cash’? Instead of a trend dominated by a shift away from risk this would represent a classic start to a bull market as money moves out and away from cash. Money in TBills moves out to 2-year bonds. Money in 2-year bonds pushes out to 5-year bonds. As yields for 5-years decline the stretch for yield adds buying pressure to 10-year and 30-year maturities. Lower Treasury yields increase the attractiveness of high-quality dividend paying stocks, and so on.

Below we show a chart comparison between the ratio of Alcoa to gold producer Newmont and the spread between 5-year and 3-month Treasury yields.

Over the past few months one of the dominant themes within the markets has been the downward squeeze between mid-term yields and short-term yields . At the start of the second quarter 5-year yields were close to 2.6% higher than TBills and by the end of last week this spread had tightened in to less than 1.4%.

From our perspective this process began around the start of the year when economically sensitive Alcoa began to weaken relative to the gold mining sector.

One of the problems that we have faced since the end of the previous quarter can be seen through this chart. Notice that the AA/NEM ratio has been rising even as the yield spread continues to decline. If the issue was only a growth slow down then our sense is that the rebound in the AA/NEM ratio would have gone with upward pressure on the yield spread. The point? A reasonably significant divergence has been created since the end of  June as the equity markets hint at improving growth even as the bond market continues to process of flattening the yield curve.

Equity/Bond Markets

We are going to continue on with our above ‘thought’.

Below is a chart comparison between the U.S. 30-year T-Bond futures and the ratio between Johnson and Johnson and the S&P 500 Index.

Typically the JNJ/SPX ratio goes with the bond market. Typically rising bond prices mean that steady growth companies with reasonable dividend payouts become more attractive relative to the broad market. The chart shows that from the Nasdaq’s peak in March of 2000 through into 2003 the JNJ/SPX ratio tracked upwards with bond prices and from mid-2007 through 2008 the ratio moved upwards as defensive stocks and Treasuries outperformed through the subprime crisis.

The point? The bond market is on fire this year but the JNJ/SPX ratio is still declining which is something of a puzzle.

Another view is shown below right through the ratio between JNJ and the TBond futures. We have argued that over the past decade a ratio above .60 for JNJ/TBonds has served as a peak for JNJ. The last time the ratio reached this level was early in the late summer of 2008.

If bond prices are rising because money is moving away from cash in search of higher yields then is this trend bearish for JNJ? Given current TBond futures prices the stock price of JNJ would have to lift around 30%  before the ratio would cross above .60. When we view the markets from this perspective it is difficult get truly bearish about the broad market even as bond prices soar.

Above we showed how the AA/NEM ratio turned higher even as the yield spread continued to decline. The chart below provides a second ‘spin’ on the argument. The chart shows that Wal Mart has been trending inversely to the combination of the TBonds times gold futures. The point is that while WMT is still below its 200-day e.m.a. line it has been working higher since the start of the current quarter.