On Monday July 16^th,  the iShares Barclays 20+Year Treasury Bond ETF (NYSE: TLT) hit a new all-time high price of $130.61, surpassing the $130.38 intraday level reached on June 1^st, which had surpassed the $125.03 intraday level on October 4, 2011. U.S. Treasury bond yields are plumbing the depths of new record lows yet again (i.e., bond prices at all-time highs):

Some investors are so fearful that the European debt crisis will result in a global economic collapse that they are willing to place their money in bonds that are paying nothing rather than risk losing money in higher-return assets like common stocks and junk bonds. It is truly an amazing – and disturbing – psychological phenomenon that seemingly suggests that the U.S. is on the verge of entering a new recession.

Or is it suggesting something else entirely?

The reason I ask is that another time-tested gauge of investor fear gauge – the S&P 500 Volatility Index (Chicago Options: ^VIX) — is flashing investor complacency (i.e., an utter lack of fear). As I wrote back in January, stock investors appear to be in “complete denial,” which is even more true now in July than back then since the VIX is now at only 16.3 compared to 20.5 in January. Any VIX number below 16 constitutes extreme complacency and thus we’re very close to such an extreme reading:

Such a divergence in the TLT and VIX fear gauges is very rare. Historically, TLT and VIX move in unison, both rising in times of investor fear and both falling in good, stress-free markets. This historic relationship of moving in lockstep started to break down in early October 2011 (right around the stock-market bottom) and has reached an unprecedented divergence. Up until early October 2011, the price difference between TLT and VIX fluctuated in a predictable and stable range of between around 65 and 85. Since then, the price difference has steadily expanding, reaching an all-time high of 114.15 on Monday July 16^th:

Source: Bloomberg

This begs the question: what does the divergence mean and which gauge is the more accurate gauge of the U.S. economy? I don’t know, but I can provide both a bullish interpretation and a bearish interpretation.

Bullish Spin

The bullish interpretation is that U.S. bond yields are being manipulated by the Federal Reserve like never before through its quantitative easing (parts 1 and 2) and its “operation twist” monetary stimulus initiatives. The Fed is buying long-term government bonds intentionally and without this artificial buying long-term bond yields would be much higher and close to “normal.” As I wrote back in October, academic studies have found that stocks lead bonds more often than vice versa.

Furthermore, investment money is leaving the Eurozone and coming to the U.S. via government bond purchases because foreign investors view the U.S. as the ultimate safe-haven economy. In other words, low U.S. bond yields are a sign of economic strength, not weakness, and are the result of weakness in Europe, not here.

Under this bullish spin, TLT is wrong and the VIX is right.

Bearish Spin

The bearish interpretation is that U.S. bond yields are signifying a global recession, which the U.S. economy cannot escape. The Economic Cycle Research Institute (ECRI) not only re-affirmed its recession call on July 10^th, but stated that the U.S. is already in recession. Virtually no one will realize the recession, however, until the U.S. Commerce Department’s Bureau of Economic Analysis (BEA) releases its final revisions of 2012 quarterly GDP numbers. U.S. economic data has worsened considerably lately, including the first below-50 reading in the ISM manufacturing index (signaling contraction) since July 2009.

From a technical chart-reading perspective, the S&P 500 is on the verge of experiencing its first “ultimate death cross,” where the 50-month moving average (1152 currently) falls below the 200-month moving average (1145 currently), since 1946.  The last stock market to experience this phenomenon was the Japanese stock market in 1998 and that death cross ushered in a 14-year bear market that is still in force. If the ultimate death cross occurs in the S&P 500, it may be time to sell everything. Unless, that is, the ultimate death cross marks the end of a bear market, like it did in 1980 when the Dow Jones Industrials experienced the death cross in August 1980 right before the greatest bull market in U.S. history.

Under this ursine spin, TLT is right and the VIX is wrong.

Gentlemen and gentlewomen, place your bets! Given the current extreme and divergent conditions in the bond and option markets, the only certainty is that a big move is coming.

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