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You gotta love the French. They are nothing if not fiercely independent. They can seemingly turn on a dime, and give you nine cents change. France was one of the first 5 nations to form the European Union movement; and the French-German alliance has been the core of pan-European cooperation. Yet, last week, the French citizenry sent Europe and the Euro reeling by being the first nation to vote down the European Union constitution. It’s not easy putting together a federation of independent states. Just ask some guys like Tom Jefferson, Tom Paine, Al Hamilton, George Washington, Ben Franklin, and John Adams. They could have given you an ear full.

In the aftermath of the French vote the dollar is stronger, gold is rebounding, the U.S. treasury market is on a bull run, and the U.S. stock market isn’t doing so badly either.

Only six weeks ago it looked like the prices of U.S. stocks and gold were sinking into bear market oblivion. It looked like we’d get to a 5 percent yield on the 10-year U.S. Treasury bond—and maybe never see 4 percent again.

Talk about turning on a dime! As recently as May 3 we wrote to you about stocks being stuck in a trading range. We no sooner got the words on paper and Ka Boom, the markets took off.

By May 16th, the shares of gold stocks, as measured by the XAU (Philadelphia Gold and Silver Index) had come dangerously close to breaking their multi-year upward trend. Now they have reversed completely and are moving up again, as is the price of gold.

One thing we can say for sure about these markets is that they have presented us with lots of surprises this year, and are keeping us on our toes.

And what of the bond market? At the beginning of the year, all the major market pundits that we know of, except one, were calling for bond yields to be much higher today than they actually are. Frankly we were included in that group. By late April it looked like all those forecasts were accurate. The 10-year U.S. Treasury bond rate bottomed out at about 3.95 percent and then quickly rose to 4.7 percent. Then bonds turned on a dime too, and yields have collapsed in just six weeks.

To their credit, the only “major market” pundit that made the right macro-call on interest rates was Merrill-Lynch. At the end of 2004 their strategists were forecasting a 3.8 percent yield on the 10- year Treasury bond by June 30, 2005. Coincidentally Merrill-Lynch was offering one of the more pessimistic forecasts on stock prices as well. Their mid-year target for the S&P 500 was 1205. Last week the S&P 500 briefly bounced back above 1200, and closed the week at 1196. The 10 year Treasury yield briefly dropped below 3.90 percent, before closing the week at 3.97.

Believe me when I tell you that no one would have believed yields could be this low at this point, other than a lonely strategist at Merrill-Lynch. Even the likes of Warren Buffett and Alan Greenspan are surprised. I am sure that even most of the daily players in the bond market are surprised. After all, the yield was almost 1 percent higher only 7 weeks ago. And, before we give them too much credit, it is probably safe to speculate that Merrill got it right for all the wrong reasons.

Why yields are this low is the major question mark for the financial markets? If everyone is so surprised, are there any good answers as to what is going on? Can we understand why, and therefore benefit by the trend? Bear in mind, if Alan Greenspan is genuinely puzzled by this condition, we are not sure anyone really has the definitive answer. But what we consider to be a potentially reasonable stab at an explanation follows.

We borrow generously from Barron’s current “Investors Soapbox” column, which is written by The Economic Outlook Group, L.L.C., P.O. Box 911, Princeton Junction, New Jersey 08550. Here is their current take on low yields.

CAN'T FIGURE OUT why the yield on the 10-year Treasury is so low? (In recent days, the yield has fallen to between 3.8% and 3.9 %.) Here are seven factors that have driven the yield down, and why it is likely remain in this neighborhood for the balance of the year.

1. Since oil has been trading in the $50 range, a new wave of petrodollars has been flooding into the U.S. Treasury market. With world oil consumption at 84 million barrels a day, the amount spent on crude by consuming nations has jumped from $900 billion to $1.5 trillion in the last year. We suspect much of that additional $600 billion in petrodollars has made its way into Treasuries.

2. There was awareness for weeks that the proposed European constitution was in trouble with French voters and that made European investors uneasy. Now that the constitution has been resoundingly defeated in France and the Netherlands, questions about the future of European integration -- and the viability of the euro looms large. Who benefits? The U.S. Treasury market.

3. While no one knows precisely when the Chinese will move to raise the value of the RMB (Renminbi), the mere anticipation that Chinese assets will shortly become more expensive to foreigners has produced yet another wave of foreign capital inflows to China. To keep the RMB within its trading range, Chinese monetary authorities, once again, have been forced to intervene and buy Treasuries.

4. The Federal Reserve continues to do an extraordinary job keeping inflationary "expectations" under control. Remember, we're not talking about inflation, per say, which has inched up a bit. Bond traders are well aware of the role energy has played in raising the CPI and PPI of late. But they also know Federal Reserve officials look primarily at core inflation numbers to determine underlying pricing pressures in the economy and here all looks benign.

This bodes well for inflation in the long term AND raises the probability that the Fed will be done lifting short term rates this summer. Both factors help prop up bond prices.

5. When comparing yields with those of Europe and Japan, the differentials continue to favor U.S. Treasuries.

6. The U.S. has a stronger, more dynamic economy which means foreigners will likely achieve higher returns on portfolio investments in this country.

7. Baby boomers, the wealthiest generation in U.S. history, are preparing for retirement by gradually selling their long-time equity holdings in order to lock up years of capital gains, and buying Treasuries for income and safety. This generational shift from stocks to bonds is expected to have a profound and lasting effect on bond prices as well.

-- Bernard Baumohl

We think that there is more than a grain of truth to each of Mr. Baumohl’s points. His short and concise explanation offers a good perspective on bond yields.

But our takeaway is that the most important point may be number 5. “When comparing yields with those of Europe and Japan, the differentials continue to favor U.S. Treasuries".

What he is implying is that the yields of treasury bonds in other major countries are, for the most part, lower than here. Therefore if you want a safe bond with a guaranteed yield you have to choose the U.S. That isn’t necessarily a ringing endorsement, when put in the overall context of current global economic conditions.

At K&A we have long contended that the bond market is a better discounter of future economic conditions than the stock market. It follows then that we can’t help but speculate that economic conditions are actually much weaker in the U.S. and around the globe than many people currently believe. That is the normal reason for yields being so low, all around the globe.

Certainly recent economic data is confirming that Europe is already slowing down to the point that Italy is technically in a recession. Germany, France and England may be rapidly following. The pace of economic growth is slowing in the U.S. China is trying very hard to engineer a “soft landing” for their booming economy. Japan continues its struggle to get its economy going.

So what is the real message that the bond market is sending? We believe the answer is “slow and decelerating growth”. Is it time to be forecasting a recession in the U.S.? The answer is no. Economic cycles never begin or end on cue. But it is time to a least consider the possibility that the current growth cycle is slowing or ending. After all, that is why they call them “cycles”!

If the cycle is ending it would not surprise us. We wrote in our 2005 report (in December 2004),

“Right now the economy seems to be on track to continue growing. The question is at what pace? The UCLA Anderson forecast expects domestic GDP growth to slow to 2.8 percent by the second half of 2005. They say, “That means rising interest rates, some weakness in housing and consumer durables, but only shaving a bit of normal GDP growth.” By 2006 “We (UCLA) are talking a recession driven by a plunge in consumer spending on homes and durables.” We are comfortable with their forecast, but would add a cautionary note that the recession could come faster than 2006 under certain circumstances.

The certain circumstances included high oil prices. We love to see the price of oil back below $40 per barrel. We’d love to see it at $28.00! Talk about fiscal stimulus for the global economy. But then we’d like to see the 49ers win the Super Bowl and the Giants win the world series too!

Cy-cle 1. An interval of time during which a sequence of a recurring succession of events or phenomena is completed. 2. a course or series of events or operations that recur regularly and usually lead back to the starting point.

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