By MICHAEL SANTOLI
THE SUMMER HEAT NOTWITHSTANDING, Wall Street is now thick with folks shivering over the collapse of Treasury-bond yields, reading it as an augur of a coming deflationary ice age.
The question, "What is the bond market telling us?" is being asked with growing urgency, mostly by folks who have settled on the answer that the bond market is conveying a message that economic- growth expectations are in peril and that the stock market—which even after last week's dip is in the upper end of its summer range—is ignoring it at grave risk.
The 10-year Treasury yield sliding to a 16-month low of 2.68% shouldn't be ignored or explained away. It's for good reason the stock market was dubbed "the bond market's idiot kid brother." Clearly, at minimum, the 10-year yield at these levels reflects the general reduction in U.S. growth assumptions, both about last quarter and the second half of the year. Yet there is probably more going on here than bonds reliably pricing in another economic contraction that would upend stocks. There's even a chance that neither stocks nor bonds have the outlook wrong. The argument between the two asset classes might instead be a subdued and agreeable discussion.
At the most basic level, both markets seem to have internalized the idea that the Federal Reserve's zero-rate policy is the law of the land for the investable future, and policy makers stand ready to throw money at the economy's problems, be they evident or hypothetical. With overnight lending rates at zero and the two-year note yield barely above half a percent in yield, the incentives for banks and other leveraged investors to simply coast along the yield curve remain strong, even at 2.68% on the 10-year.
There have also been hints that some of the buying pressure on 10-year Treasuries looks forced or mechanical, related to hedging by mortgage-bond investors. One thing is sure: The rally in longer-term Treasury paper hasn't been supported by the largest U.S. bond investor. Pacific Investment Management, which Bloomberg recently reported is taking in $1 billion a week from bond-craving investors, reduced U.S. government-related holdings in its flagship Total Return fund in July from 63% to a still-high 54%.
A more salient rejoinder to the admonition to heed the bond market is, "Which bond market, exactly?"
Because in contrast to the purported economic malaise and acute risk aversion being foretold by teensy Treasury yields, the corporate bond market hasn't flinched at all.
The iShares iBoxx Investment Grade Debt exchange-traded fund (ticker: LQD) traded at nearly a five-year high last week. The iShares iBoxx High Yield Corporate Bond ETF (HYG) has held steady in the last three months, as the 10-year Treasury yield sank more than 20%. If economic and corporate fortunes were due to erode quickly, corporate debt would presumably be sniffing this out as well.
For sure, corporate debt is supported by a couple of strong tailwinds. Very slow but positive economic growth is something near a nirvana state for credit, as strategists at Morgan Stanley noted. Companies can handily service their debt without necessarily growing rapidly, and a sluggish recovery forestalls inflationary fears that can poison returns.
And, of course, the public is bingeing on bonds, and has been for years. In the first half of 2010, investors sent $136 billion in net new money into bond mutual funds, taking the total net inflow since the start of 2009 above $500 billion.
Corporate America has been availing itself of the public's willingness to lend, as the widely noted International Business Machines (IBM) sale of three-year notes at a 1% rate attests. The percentage of new corporate-capital issuance in the form of equity is near a 20-year low. History suggests that what companies are most eager to sell isn't the best buy, and vice versa.
The risk isn't necessarily that there's a bond "bubble," as is commonly heard (especially from folks who sell stocks). A bubble requires that the public be whipped up into a state of enthusiasm over some grandiose "story" about a certain asset class. That isn't happening, unless one considers the sober demographic argument in favor of income instruments.
No, one take-away is that bond investors better be happy with the coupon, because not much absolute appreciation is likely from current levels. And most probably are.
Another is that if the environment remains OK for corporate credit, then it shouldn't be terribly hostile to equities. J.P. Morgan noted last week that the forward "earnings yield" of the Standard & Poor's 500 based on current forecasts is 8.1%, while high-yield bonds were at 8.3%—the narrowest spread in history (it has averaged 5.1% since 1987).
Telling a similar story in a different way, the dividend yield of the Dow Jones Industrial Average components, at 2.65%, is essentially equal to the 10-year Treasury yield. The folks at Morgan Stanley note that over the past 50 years the Dow's yield has exceeded that of the 10-year Treasury for only one period—the end of 2008 into early 2009, as the financial crisis climaxed.
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LONDON—Less than a month after stress tests calmed concerns about the health of European banks, new problems in the Irish banking sector are making investors nervous once again.
The combination of events has made it more expensive for Ireland to borrow and driven the country's credit-default insurance costs 36% higher since the start of the month, to levels last seen just ahead of the European banking stress tests.
The renewed troubles in Ireland offer the latest hints that the recent stress tests of 91 big European banks haven't accomplished their central goal: easing concerns about the health of the continent's financial institutions and, by extension, reducing fears about deeply indebted sovereigns, such as Ireland.
EU regulators announced the test results on July 23, showing that just seven of the 91 tested banks would need more capital in a worst-case scenario. The upbeat results seemed to cheer the markets, with bank stocks rallying and the cost of insuring their bonds against default declining.
But problems have started to crop up again. Bank stocks have tumbled, with the Stoxx Europe 600 banking index down about 8% in the last two weeks. Bank funding costs have climbed, a sign of wariness among banks and investors about the sector's conditions.
Lenders in southern Europe have increased their reliance on the European Central Bank as a source of funds, according to data released Thursday by central banks. Greek banks boosted their borrowings in July by about 2.5% from June, Portuguese banks' ECB borrowings jumped by about 21% and Italian banks borrowed an additional 12%.
"The evidence this week seems to indicate that the stress tests might have failed to ring-fence the periphery" of Europe, Royal Bank of Scotland's Andy Chaytor and Nick Matthews wrote in a research note Thursday.
For right now, Ireland's problems have moved to center stage. On Thursday, the government sold €1 billion in six- and eight-month treasury bills, paying 2.458% on the six-month note, a big jump from the 1.367% yield it paid at the last auction three weeks ago. The yield on the 10-year bond rose to 5.367%, 2.94 percentage points higher than the relative German bund and up almost half a percentage point from one week ago.
Philip Lane, a professor of international and macro-economics at Trinity College in Dublin, said Anglo Irish's call for more capital is troublesome and there are worries that the deeper the government digs into its loan book, the more problems it could find.
Still, he said, "Financial markets can go into panic mode, and it's hard to say that the Irish fundamentals are sufficiently bad to warrant these spreads."
Problems in the Irish banking sector stem from Ireland's collapsed commercial-real-estate sector, where the market for office developments and build-able land has become illiquid. Anglo Irish was particularly exposed to these toxic commercial-real-estate assets.
In May, the bank sold about €10 billion of such loans to the National Asset Management Agency, or NAMA, at a discount of nearly 55%. But Anglo might be facing an even tougher haircut on its coming asset sales. NAMA said last month that it applied an average 48% discount to assets it received from four other Irish lenders, which analysts generally view as having healthier balance sheets than Anglo. Loans from one of those institutions—Irish Nationwide Building Society—faced a severe 72% haircut.
The fact that Anglo's loans weren't included in the mid-July transfer to NAMA has fueled speculation that Anglo will be forced to accept a higher discount than it did in its previous transfer, which would further erode the bank's capital buffer. A NAMA spokesperson couldn't be reached Thursday.
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—Margot Patrick contributed to this article. Write to David Enrich at david.enrich@wsj.com
But problems have started to crop up again. Bank stocks have tumbled, with the Stoxx Europe 600 banking index down about 8% in the last two weeks. Bank funding costs have climbed, a sign of wariness among banks and investors about the sector's conditions.
Lenders in southern Europe have increased their reliance on the European Central Bank as a source of funds, according to data released Thursday by central banks. Greek banks boosted their borrowings in July by about 2.5% from June, Portuguese banks' ECB borrowings jumped by about 21% and Italian banks borrowed an additional 12%.
"The evidence this week seems to indicate that the stress tests might have failed to ring-fence the periphery" of Europe, Royal Bank of Scotland's Andy Chaytor and Nick Matthews wrote in a research note Thursday.
For right now, Ireland's problems have moved to center stage. On Thursday, the government sold €1 billion in six- and eight-month treasury bills, paying 2.458% on the six-month note, a big jump from the 1.367% yield it paid at the last auction three weeks ago. The yield on the 10-year bond rose to 5.367%, 2.94 percentage points higher than the relative German bund and up almost half a percentage point from one week ago.
Philip Lane, a professor of international and macro-economics at Trinity College in Dublin, said Anglo Irish's call for more capital is troublesome and there are worries that the deeper the government digs into its loan book, the more problems it could find.
Still, he said, "Financial markets can go into panic mode, and it's hard to say that the Irish fundamentals are sufficiently bad to warrant these spreads."
Problems in the Irish banking sector stem from Ireland's collapsed commercial-real-estate sector, where the market for office developments and build-able land has become illiquid. Anglo Irish was particularly exposed to these toxic commercial-real-estate assets.
In May, the bank sold about €10 billion of such loans to the National Asset Management Agency, or NAMA, at a discount of nearly 55%. But Anglo might be facing an even tougher haircut on its coming asset sales. NAMA said last month that it applied an average 48% discount to assets it received from four other Irish lenders, which analysts generally view as having healthier balance sheets than Anglo. Loans from one of those institutions—Irish Nationwide Building Society—faced a severe 72% haircut.
The fact that Anglo's loans weren't included in the mid-July transfer to NAMA has fueled speculation that Anglo will be forced to accept a higher discount than it did in its previous transfer, which would further erode the bank's capital buffer. A NAMA spokesperson couldn't be reached Thursday.