What if the Bond Guys Are Right?

Signs abound that 2007 will be good for equity investors. We’re coming into the third year of a presidential cycle, which is historically the best year for stocks. Earnings continue to dazzle analysts and investors; inflation, while above 2%, seems to be holding steady; and the housing market, once thought to be on life support, showed surprising resiliency in December.

The only non-believer seems to be the bond market. The current yield curve is inverted, an unusual scenario when the yield on longer-maturity government securities is lower than on shorter-term paper. An inverted curve has preceded each of the last six recessions since 1970; as a result, its utility as a precursor of economic trouble is well deserved. Bond participants seem convinced that trouble is ahead, and a shrinking economy would no doubt put a damper on rising stock prices.

But the world has changed a lot since the last inversion occurred in 2000. First off, the large pile of offshore cash committing to long-term U.S. government bonds has changed the structure of the yield curve. With more demand for longer-term paper, inverted curves will likely be more commonplace, especially in an environment of stagnant rates.