Bond investors are by nature pessimists and stock investors are by nature optimists. But this market maxim does not fully explain the seemingly wide gap developing between the two camps’ views on the U.S. economy and looming interest rate cuts.
Interest rate markets are currently pricing in an aggressive Fed easing cycle, which historically accompanies severe market shocks, a recession, or both. On Wall Street, however, stock prices remain near all-time highs and earnings growth is expected to exceed 15% next year.
Something is not right there.
HALF EMPTY?
The bond market is often said to be a more reliable weather vane for economic and monetary policy than the stock market. But the bond market has been wrong for years. It consistently underestimates the resilience of the US economy and has been hasty on several occasions when it comes to giving the starting signal for the Fed’s easing cycle.
Interest rate futures are pricing in a cut of almost 100 basis points for the three remaining Fed meetings this year, 150 basis points for March and 200 basis points for September next year. The negative spread between the key interest rate and the yield on two-year US Treasuries is at a historic level.
This level of implicit easing is consistent with the early 1990s recession, the dot-com crash, the global financial crisis and Covid-19, said Bob Elliott, CEO of Unlimited Funds and former manager of hedge fund giant Bridgewater.
“The current pricing for such rapid cuts is consistent with the depths of previous recessions or crises, not with stock prices, which are essentially at all-time highs,” Elliott says.
And even though US interest rate futures markets have calmed down considerably since the volatility shock of August 5, the probability that the Fed will cut interest rates by 50 basis points at its September meeting is still one in four.
The only times in the modern era that the Fed began an easing cycle with a half-percentage point cut were in January 2001, September 2007, and October 2008. Two of those moves were emergency measures, the other followed two Fed conference calls discussing signs of severe market stress that were emerging at the time.
OR HALF FULL?
Meanwhile, stock prices are certainly not prepared for a recession.
After the recent correction triggered by the unwinding of several crowd trades, a sell-off in mega-cap Big Tech companies and a sharp volatility shock, stocks have staged a remarkable recovery, with the S&P 500 now within 1 percent of its July record high.
Shares of Nvidia, the fairy-dusted symbol of the future of artificial intelligence, for example, recovered 43 percent in just two weeks.
But it’s not just the big tech companies that stock investors are excited about. The second-quarter earnings season, which is about to wrap up, shows that profits for S&P 500 companies rose 13.4 percent year over year, 5.1 percentage points more than estimates at the start of the season. Nine of 11 sectors reported higher earnings.
And the consensus estimate for overall S&P 500 earnings growth for next year is even higher, at 15.2%, according to LSEG/Refinitiv data, with earnings growth expected in every sector. Some of the market’s optimism is undoubtedly based on expectations of a lower discount rate, but the outlook for consumers and corporate earnings is not all that bleak.
Is the stock market right?
So what does the bond market see in contrast to the stock market?
One could argue that this divergence is a mirage that can be explained by looking at the real – that is, inflation-adjusted – federal funds rate and changes in the so-called R-Star value, which is the Fed’s estimate of a long-term neutral interest rate that neither stimulates nor weakens economic activity.
As inflation has eased over the past year, the monetary policy target range has remained stable at 5.25-5.50%, pushing real Fed funds rates up to nearly 3%, the highest since 2007.
The Fed’s R-Star is 2.8%, meaning that the Fed could cut interest rates by 250 basis points and still be considered “strict.” So perhaps significant rate cuts don’t necessarily have to be accompanied by a recession or crisis?
But considering the still low unemployment rate, the reasonably healthy economic growth and the tight credit spreads for investment- and junk-rated companies, it can hardly be said that monetary policy is all that restrictive.
Perhaps this is another example of why the rules of the past simply do not apply when judging today’s economy. Regardless, the stock market appears to be on firmer ground.
“If you look at the earnings, it doesn’t look like we’re in a recession,” says Callie Cox, chief marketing strategist at Ritholtz Wealth Management. “I would trust the stock market in that scenario. The stock market is right – the economy is still in a good position.”
Usually the bond market is right. But maybe this time it really is different.
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