Q2 2014 GDP was reported in July at a blistering 4% annualized rate. I’ve expressed my doubts about the strength of the economic recovery, and on the surface this looked to be my comeuppance. However, digging into the numbers tells a different story.

My last post commented on my expectation that GDP would be in the 2% handle. To get there, I assumed inventories would be zero. They were actually 1.66% of the 4% print. There are two ways to interpret inventories. The optimist says that businesses accumulate inventories because demand is good and they expect to sell more in future quarters. The pessimist says businesses accumulate inventories because demand is poor and they didn’t sell as much as they expected. I don’t try to interpret things either way – I tend to put low weight on their importance in determining trend growth, just as I do with government expenditures.

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Is this a good sign or a bad sign?
The following shows GDP measured using the product of the trailing four quarters, with and without inventories. Irrespective of which measure we use, growth is running at about 2%. That’s a far cry from the escape velocity normally seen with recoveries.

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Nothing too exciting no matter how you count (source: BBG)

Some will cry foul here and suggest I’m manipulating the data to support my cause, much like the Bureau of Labor Statistics does when they drop food and energy out of the inflation number. These folks will insist that the 4% print is not only legitimate, but is the harbinger of higher GDP prints and higher rates. But the markets interpreted the GDP number with the same skepticism I did. 10-year yields ended the month lower than where they started (2.55% versus 2.56%).

Being short 10-year notes is a pain trade, in my view. The negative carry and steep roll, the slow growth in the US and geopolitical uncertainty have humbled many a smart trader who said “Rates can’t go lower” at 2.50% only to see them today at 2.35%. But I believe the biggest driver for rates in the next 12-months will be the German Bund.

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A bull market for bonds (source: Bloomberg)

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Approaching historic wides (source: Bloomberg)

The Bund-treasury yield spread is approaching historical wides. Can we get a 3% treasury when Bund yields are below 1%? I don’t think so. As we reach the wides, I expect a giant “swooshing” sound to be heard, with European money flooding in to buy “yieldy” US treasuries. This will complicate things for the Fed should they actually want to tighten, though my guess is we’re still a long ways off from that event. Until then, watch the positioning in treasuries. A major shakeout in positions could push us out of the range – and racing toward 2%. That would be a boon to the mortgage market, as refi volume continues to trudge along at a 20-year low.