23/09 What the financial markets are telling us about the economy

 at 01:53 PM ET, 09/23/2011

(Jin Lee - AP)
Markets can get it wrong. Sometimes briefly (the flash crash of May 2010) and sometimes for years (the dot-com boom). But prices in financial markets do convey something about the best guess of where the world is heading, and if you know how to interpret prices you can gather what the cumulative wisdom of every financial whiz who is trying to trade for a profit. 
So, after firing up the Washington Post Bloomberg terminal and poking around a bit, here’s what those markets are telling us. (All prices are at approximately 1:00 p.m. Friday) 
First, bonds. Ten year U.S. Treasury bonds are currently in such high demand that investors are willing to settle for a yield of only 1.77 percent; that level was even lower, an all-time record low as it happens, on Wednesday. At current stock market levels the Standard & Poor’s 500 is paying dividends of 2.3 percent. 
Usually it’s the other way around: The government typically must pay a higher yield on its bonds than the stock market pays out, because investors expect stock prices to rise over time whereas bonds only pay back the amount invested after a decade. 
The earnings of the Standard & Poor’s 500 companies add up to 8 percent of their combined stock market value, which is unusually high at a time that Treasury bonds are yielding 1.8 percent. That suggests investors are quite fearful about the corporate sector encountering rough years ahead. 
Over the longer run, the story is similar. Thirty year Treasury bonds are yielding 2.8 percent, down from 4.4 percent on July 1 and also near an all-time low. Global investors are willing to fling money at the U.S. government for nearly nothing. 
How about inflation?  By looking at the difference in yield between bonds that are indexed for inflation and those that aren’t, you can discern the market's inflation expectations (the analysis isn’t perfect, because different types of bonds have different degrees of liquidity, but the basic idea works). 
Just two months ago, financial markets were projecting that inflation would be near the 2 percent or so level that the Federal Reserve aims for. But now, markets are expecting annual inflation over the next five years of 1.3 percent, well below that level. Over the next decade, inflation is expected to be very low as well: Markets expect 1.6 percent annual inflation over the coming decade, down from 2.4 percent at the beginning of August. 
And while high oil prices stymied U.S. economic growth earlier in the year, markets are not seeing higher oil prices anytime soon. Futures markets prices predict that a barrel of West Texas Intermediate Crude, $79.92 today, will go for $82.86 in 2012 and $86.20 in 2015—higher, but still well below levels of just a few months ago. 
How about all this volatility in the stock markets? There have been 16 days since Aug. 1 when the stock market moved more than 2 percentage points in either direction. There were only two such days in the first six months of the year. 
One key index predicts the volatility will continue. The VIX index captures the amount of stock market volatility implied by the prices of options. It is at 41 today, up from a recent low of 16 on July 1—in other words, investors expect the stock market to be more than twice as volatile now as they did then. That said, expected volatility is still below its recent high on Aug. 8, and well below the record high of 81 reached in November 2008. 
So put all these numbers together, and what are the financial markets telling us? 
Nothing good, unfortunately. The markets may not be pricing in a certainty of a U.S. recession, but they see significant odds of one. And even if a recession is technically averted, there is no apparent confidence that the economy will begin growing rapidly anytime soon. 
We can only hope that, like in the dot-com bubble, this is one of those times when these allegedly efficient markets have gotten it wrong.

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