As diligent traders, investors, or even spectators, we are taught not to take too seriously the price action and market movement that takes place in the quieter late summer months. Still, even with this in mind, what the bond market is trying to tell us cannot be ignored. As I drown myself in research regarding the subject, all the publications I read religiously seem to be trumpeting the same thing: the outlook for recovery is gloomier than we thought.

But how much can we ask for here? If deflation is the ultimate fear, as illustrated by, among other things, the flood of investors into treasuries which pushes TIPS into negative real yields, then why did equities not get the memo? Yesterday equities rallied on positive earnings reports from Home Depot, Walmart, Urban Outfitters, and Abercrombie, among others, coupled with potential M&A activity and better than expected data. Wholesale inflation pressures rose in July for the first time in four months with annual core prices jumping to 10 month highs of 1.5%, industrial production rose more than forecast by 1%, and even ABC consumer confidence rose to -45 from -50. We all know one day does not a recovery make and I tend to listen to bonds which see the macro forest for the trees and are telling us their bull trend is still intact.

While the whole balance between deflation, disinflation, and inflation is generally elusive as to what is best for economic recovery and what we should trade on, I agree with both Hoenig and Kocherlakota that rates at zero to 25 basis points for too long could actually feed into a deflationary scenario. In spite of the most recent Senior Loan Officer’s Survey, we know it doesn’t inspire banks to lend to eachother. Right now bonds say deflation, equities don’t seem to care either way, and everyone and their dog wants to read into the FOMC action last week to reinvest maturing mortgage bonds into Treasuries. Was it enough? Is there more to come? If so, in how long? Are bonds rallying in response to this or is the real driver of the rally a further deterioration in growth expectations vs. deflation risks? One thing we can be sure of, as Larry Kudlow points out in his latest blog post, “Economic Lessons of the Summer Swoon (http://www.cnbc.com/id/38739767),” fiscal policy should NOT be the main driver of market action.

It is summer after all. Stay tuned.

FT Lex Column:
http://www.ft.com/cms/s/0c3ccb62-a9db-11df-8eb1-00144feabdc0,Authorised=false.html?_i_location=http://www.ft.com/cms/s/3/0c3ccb62-a9db-11df-8eb1-00144feabdc0.html&_i_referer=http://www.ft.com/intl/lex

WSJ: The Great American Bond Bubble:
http://online.wsj.com/article/SB10001424052748704407804575425384002846058.html

FT Short View:
http://www.ft.com/cms/s/0/9c304356-aa45-11df-9367-00144feabdc0.html

Larry Kudlow's Blog:
http://www.cnbc.com/id/38739767)