EC HH Face Off: Stocks Vs. Bonds And The Economic Outlook

There is a healthy debate between those who work in fixed-income markets and those in the equity markets about who is better at assessing markets. The skepticism of bond guys and gals seems to help them identify turning points. The optimism of equity pros lends to catching the full run of a rally. As an ex-bond trader, I have a hunch but refuse to risk offending our equity-oriented clients by disclosing it. In all seriousness, both professions require similar skill sets to determine an asset’s fair value with the appropriate acknowledgement of inherent risks. More often than not, bond traders and stock traders are on the same page with regard to the economic outlook. However, when they disagree, it is important to take notice.

We created the Trump Range Chart a few months ago to easily track a number of asset classes, gauge the durability of post-election market moves and monitor divergences. In the May 23, 2017 update to that chart, we noted that some indicators such as the Treasury yield curve, regressed to levels observed prior to the election. At the same time, many of the popular equity indexes continue to power ahead to new record highs. The bond market seems to be telling us that the probabilities of the reflation trade have dropped considerably. Meanwhile, the stock market appears to remain convinced that the prospects for growth and reflation are alive and well. Can they both be right?

Given our opinions on the severe economic headwinds facing economic growth and steep equity valuations, we believe this divergence poses a potential warning for equity holders. Accordingly, we thought it appropriate to provide a few graphs to demonstrate the “smarter” guys are not on board the growth and reflation train.

The graph below shows that the U.S. Treasury 2-year/10-year curve which, having gapped almost 75 basis points wider following the election, has reverted back to pre-election levels. Alongside the yield curve is the S&P 500, which continues reaching new highs since the election. The election date in this graph, and all graphs that follow, is highlighted with the vertical dashed line.

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720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.Our objective is to provide professional investment managers with ...

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Adem Tumerkan 4 months ago Contributor's comment

I just wrote an article also discussing the divergence. To me its more the Bond market vs the Fed. Bond investors expecting deflation and recession and disbelieving the Feds optimism for inflation and higher growth.

I also use the recent data showing falling loan origination markets...

If the Fed continues hiking and long term rates keep falling as economic data worsens, we're looking at an inverted yield curve. Which almost certainly will mean a recession.

Good article Sir.

Bill Johnson 4 months ago Member's comment

Thanks Adem Tumerkan, what's the link to your article? Sounds good.

Adem Tumerkan 4 months ago Contributor's comment
Gary Anderson 1 month ago Contributor's comment

I liked your article, Adem. But clearly, bond demand seems more and more divorced from the real economy, from anything other than its own internal market demand.

Gary Anderson 4 months ago Contributor's comment

Bonds may not be a reliable indicator as you also say. Bond demand is shown to be strong in times of boom and bust under the new normal.