In This Market, It's Best to Heed Bonds, Not Stocks
Equities and bonds have been giving different signals to investors over the past two months. Stocks, measured by the S&P 500 Index, have been on a steady march upward, boosted by impressive corporate earnings in the first quarter. While optimism about “Trumpflation” -- tax cuts and infrastructure spending -- pushed the yield on 10-year Treasuries from a low of 1.80 percent on Nov. 2 to 2.63 percent on March 13, the yield has since fallen significantly, to 2.23 percent on May 30.
In the chart below, the 10-year Treasury yield is shown on the left scale (solid line), and the S&P 500 Index on the right scale (dotted line).
To add to the confusion, the spread between two- and 10-year Treasuries started to narrow even before the 10-year yield commenced its decline. After hitting a peak of 135 basis points on Dec. 22, the two- to 10-year spread moved steadily downward, reaching 93 basis points on May 30, below where it was before Election Day.
What are the divergent messages from equities and bonds telling investors, and which indicator is likely to be the best predictor of where the economy and markets will be, say, a year from now?
Continued strength in equities is traceable to an estimated 13.6 percent increase in first-quarter earnings for the S&P 500 companies compared with the first quarter of 2016. Not only did the pace surprise analysts on the upside, it was also the fastest growth since the third quarter of 2011. Furthermore, corporate repurchases of shares appear not to have been a significant factor in the increase in earnings, suggesting that the rise may be sustainable in future quarters.
While equity investors focused on the positives from a bottom-up point of view, bond investors appear more concerned about top-down factors. The pace of first-quarter growth in U.S. real gross domestic product was revised higher to 1.2 percent, which was still slow for this late in the business cycle. And with the difficulties the Trump administration has had in having Congress approve health-care reforms, and the expected delay in implementing fiscal stimulus, the 3 percent annual GDP growth target appears increasingly elusive. Adding to economic factors is the force of investors’ risk aversion due to the increase in political peril from the various ongoing investigations in Washington.
Alongside the continued slow pace of economic growth, markets are also concerned by the repeated failure of inflation to rise to levels expected by the Federal Reserve. For example, core CPI (excluding food and energy) rose by only 0.1 percent in April after a 0.1 percent decline in March. April’s inflation was also below the 0.2 percent that the Bloomberg consensus had expected. Including April, the annual inflation rate has fallen to 1.9 percent from 2 percent the previous month. Clearly, there is no sign of accelerating inflation.
The Fed minutes released May 24 suggest that authorities may well increase the federal funds rate by another 25 basis points at their next meeting on June 14. The recent benign inflation figures suggest, on the other hand, that the Treasury yield curve may well flatten, rather than steepen, after the rate hike. In other words, the two- to 10-year yield spread will likely narrow further.
Judging by history, the bond market and, in particular, the two- to 10-year spread, seem to be a better indicator of the economy and markets. In 2006, the last full year before the recession began in December 2007, there were similar contradictory messages from the equity and bond markets, with bonds turning out to be a better predictor of the economy, equities and the fixed-income market itself.
In the following chart summarizing equity and bond market behavior in 2006, the two- to 10-year spread is shown on the left scale (solid line), and the S&P 500 Index is on the right scale (dotted line):
As the S&P 500 Index rose to successive new records in the second half of 2006, the two- to 10-year spread fell from a high of 21 basis points in May to a negative 12 basis points at year-end. The direction of the move -- a sharp decline -- in the yield spread in the final eight months of 2006 was a precursor not only of the recession a year later, but also of the plunge in equities and bond yields that followed.
History seldom repeats in predicting the future of markets. But it is always an important input that investors can ignore only at their own peril. With the ongoing economic recovery long in the tooth at 94 months, it behooves investors to pay greater attention to calls for greater caution that are coming from the Treasury market.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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