What the bond markets are saying

It's often very important for equity investors to look at what the bond markets are saying.

The long-term yields of US Treasuries have stabilized after the December FOMC meeting. They were creeping up since the Fed indicated its intention to do QE2, and especially after the bi-partisan decision to extend Bush-era tax cuts. US government has no trouble borrowing. The upward sloping yield curve is re-assuring for bank stocks and general equities.

European countries are a different story. The Euro crisis is pretty much still with us. Credit spreads for Greece and Ireland continued to climb in recent weeks. The Greek bond spread is now wider than it was in May, 2010 before it was bailed out by EU and IMF (see Atlanta Fed Financial Highlights). All eyes are now on Portugal as its government are trying to convince investors that they can narrow their budget gaps. The yield on Portuguese 10-year bonds stood at over 7 percent as of last week, according Bloomberg. Can ECB and IMF manage the situation before the crisis spreads to Spain? Investors are not convinced.

In the US, a worrisome development continues to be the muni market and state budget crisis. Illinois is the poster-child of the fiscal mess. The state's bonds have the highest spreads of any state. Illinois's 10-year bond spread has widened in recent weeks to 2.1 percent above the benchmark. A year ago, that spread was less than 1 percent... meanwhile, Bernanke's testimony last week made it clear that the Fed has very limited power to bail out the states.

The bright spot is US corporate bonds. Companies are taking advantage of investors' hunger for yield and the general belief that the corporate sector is healthy and may be poised to deliver the much-needed hiring. Corporations have sold more than $35 billion of investment grade bonds in the first week of 2011, according to the Wall Street Journal, on track to reaching the highest amount sold in the year-opening week since 1995.

Taken together, we agree that it may be wise to invest in US equities, and focus on companies that conduct businesses in states that are relatively healthy and can take advantage of the needs from the emerging markets. Avoid European exposures for now. And be vigilant about systemic risks posed by the Euro crisis and the US state budget crisis.

We do not think China's and India's inflation problem pose such a systemic risk to global financial markets, but it's something to watch out for.