Wells Fargo's Paulsen Warns of Rapid Rise in Treasury Yields

Deflation and a double-dip recession have become hot conversation topics for economists, even if the conclusion of their jawboning tends to be that these insidious developments have little chance of occurring. Investors let their wallets do the talking, and they are sending mixed signals.

Stocks remain near rally highs. They seem to be meandering with urgency, if that's possible, but indicate no sense of foreboding. Treasury bonds have also had a strong advance, though, sending their yields, which have an inverse relationship to prices, below 3 percent, close to 60-year lows and a level consistent with a recession and consumer prices that are stagnant at most.

That's not the sort of environment in which businesses thrive, so something's got to give. Either stocks are due to fall or Treasury bonds are. If you're the cynical sort, then maybe you'll be on the lookout for a combination of the two, making everyone unhappy.

James Paulsen, chief investment strategist at Wells Capital Management, part of Wells Fargo (WFC), seldom betrays any cynicism and has maintained a rosy outlook on the economy and the stock market. Sure enough, he anticipates a big decline in Treasury bond prices and a rise in yields.
Paulsen acknowledges in a report for Wells clients that the plunge in yields has been "breathtaking and unnerving" as concern about the economy has intensified. He's not worried, he says, because he has seen it all before, not that long ago:

"Surprisingly, the behavior of the bond market in the last year has very closely paralleled the beginning of the last economic recovery. Then, as now, after a brief recovery hiccup, the 10-year Treasury bond yield collapsed to almost 3 percent during the summer of 2003 amidst an intensifying deflationary scare. Thereafter, however, the economic recovery strengthened, deflation fears subsided, and bond yields quickly reversed and surged higher.
"Although current action in the bond market may not continue to emulate the last recovery, its similarity to that time merits consideration. . . . In late 2002, economic reports started to improve and the 10-year Treasury bond yield quickly rose from about 3.5 percent to about 4.25 percent. This year 'better economic reports' caused yields to rise from about 3.2 percent in late 2009 to almost 4 percent in early April.
"In the spring of 2003 and again this spring, the 10-year bond yield began a rapid and significant collapse, declining in both cases from about 4 percent to about 3 percent. Not only were the speed and magnitude of these bond market movements remarkably similar, the catalyst producing their collapse was the same - intensifying deflation fears."
Paulsen's conclusion, caveats aside, is that the pattern will continue, and that does not bode well for bondholders. After the initial rise and fall earlier in the decade, Treasury yields went on a sustained recovery, in line with rebounding economic growth. The same is likely again, in his view, for yields and the economy alike.

"As the 2003 example illustrates, bond yields could surge higher far more quickly and by far more than most now think likely."
On Thursday, the implications for the stock market if Paulsen is right and an alternative viewpoint on Treasury yields.