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Is the bond market wrong?

Have we gone from a Trump bump to a Trump slump

J. Eric Kelly //May 18, 2017//

Is the bond market wrong?

Have we gone from a Trump bump to a Trump slump

J. Eric Kelly //May 18, 2017//

Interest rates and stock prices tend to move in similar patterns over time — when times are good, stocks and interest rates rise; when the economy softens, stocks and rates go down. This is the natural relationship that tends to unfold during normal market cycles. Lately, these two have decoupled, with rates falling as the stock market continues to rise — forcing us to ask the question:

 “Is the bond market wrong?”

Trump bump to Trump slump

After the surprise election results in 2016, domestic markets experienced the “Trump Bump,” which entailed a traditional risk-on shift — stock values and interest rates both shot higher in anticipation of a boost to economic activity and inflation.

However, after a few months of treading water early this year, interest rates began a steady decline. The 10-year Treasury note dropped from 2.60 percent to 2.25 percent in just a few weeks.

This occurred despite an early increase in overnight rates by the Federal Open Market Committee (FOMC) and clear messaging that they are prepared to continue the upward march in rates as part of a gradual “normalization.” All the while, stock prices remained resilient and repeatedly bumped up against all-time highs.

Debates and head-scratching

The drop in long-term rates created a flattening of the treasury yield curve, something that typically occurs near the end of a Fed tightening cycle, as the economy begins to slow down.

This rate drop and curve flattening has triggered a healthy debate throughout the investment industry. It appears the bond market is signaling that the economy isn’t going to be nearly as strong as the equity market is discounting.

Historically, a flattening yield curve has been a strong, early indicator of economic deceleration — so the divergence between stock prices and interest rates has unleashed some serious head scratching.

Disagreement abounds

As a further complication, the Fed Funds futures market — the bond market’s estimate of where overnight rates are headed — is substantially below the FOMC’s estimates for where they’re planning to move rates. The FOMC expects overnight rates (and money market rates) to head to 1.5 percent in 2017 and rise to 2.2 percent in 2018, which is good news for savers. However, the futures market is placing overnight rates at only 1.25 percent and 1.50 percent in 2017 and 2018.  

It appears that the bond market currently disagrees with both the FOMC and the stock market on the strength of the economy and the path of rates, raising the question, “Is the bond market wrong?”

Countering the contrarian view

At this point, our answer is “Yes, we believe the bond market is wrong.” 

While it’s usually not fruitful to bet against the bond market, we believe several factors are causing it to paint a contrarian (versus the stock market) picture at this time:

1)Assumption that the new administration will not get any stimulus plans enacted

The bond market appears to be responding to the president’s early challenges with enacting campaign promises.

  1. Global interest rates

Global interest rates are still well below the U.S. The glut of excess savings from around the world is still chasing U.S. rates whenever they rise, making it difficult for our rates to rise as much as they might otherwise.

3)Normalization cycle

Bond investors around the world are assuming the current Fed normalization cycle will play out in a similar manner to how the entire global financial crisis cycle has unwound—much slower than anyone anticipated. They are betting against any “upside surprises” for the economy or inflation, and it’s been a very long time since we’ve had either.

4)Extreme caution in rising rates

The bond market believes the FOMC will exhibit extreme caution in edging rates higher because it fears rising rates will tip the economy back toward a slowdown.

The bond markets are not signaling that an economic slowdown is eminent, but rather that rate normalization will not be possible at the pace indicated by the Fed and most forecasters.

Why we believe the bond markets are wrong:  

  1. We believe the new administration will succeed in enacting tax cuts and infrastructure programs—both will involve compromise and delays, but they will ultimately be accomplished, and both should point toward higher rates.
  2. We believe the global savings glut is in the very early stages of abating, so the artificial “lid” on interest rates may be slowly dissipating.
  3. While the last decade has been one of extremely slow movements from the Fed, it appears wage pressure is building throughout our economy—a precursor to inflation. Economic momentum is turning upward in Europe as well. These trends will allow the Fed to push forward with rate normalization at the pace reflected in most forecasts
  4. Interest rates are exceptionally and unsustainably low, particularly given that we are experiencing a modest global upturn. Even after the Fed’s projected upward adjustments, interest rates will still be exceptionally low—modestly higher rates are not a threat to the economy or a barrier to normalization. For these reasons, we believe the bond markets are not properly reflecting the most likely path for interest rates over the next two years. There are risks to this outlook, but the most likely outcome is an upward shift of roughly 1.00-1.50 percent over the next two years.