J. Andrew Concannon
What is one to make of the markets over the past six months? First the stock market fell 20% and bond yields declined, both correctly predicting a slower economy. Then in late December the stock market, in an apparent vote of confidence in the economy, began a rally that has taken it back close to its all-time high.1 The bond market, however, stayed on its prior course with yields on longer maturity bonds falling until, for a brief two days, the 10-year Treasury bond’s yield was slightly below the 3-month Treasury bill’s yield. Many observers consider this crossing of yields, known as an inverted yield curve, to be a predictor of recession.
So is it really possible that stock-market investors believe all is well at the same time that bond-market investors fear bad times ahead? Or, is there another explanation for the seemingly conflicted behavior of the two markets? We believe the two markets’ recent behavior is actually complementary and is caused by both taking cues from the Federal Reserve (Fed).
The current Fed interest rate cycle is unlike any prior cycles today’s investors have witnessed. In past rate cycles, the Fed raised the federal funds rate2 to head off rising inflation. During the current rate-increase cycle, however, the Fed hasn’t needed to combat inflation. Rather, the Fed has attempted to normalize short-term interest rates after holding them at zero for seven years following the 2008 financial crisis. To do that, the Fed needed to identify windows of economic strength to raise rates without sinking the economy. After a slow string of rate increases beginning in late 2015, the Fed saw last year’s stronger economy as its opportunity to raise the federal funds rate more aggressively.
But, though the Fed may have been right on the economy, the markets took exception. Last fall when the federal funds rate reached 2.25%, with indications of more increases to come, investors began to worry that the Fed might push the economy into recession. Those concerns came to a head in December when the Fed raised the rate to 2.50%, thereby causing markets to throw a fit. Taking its cue from the markets, the Fed changed course in January, announcing it was putting future rate changes on hold.
The bond market has interpreted the Fed’s announcement as a signal that its next interest rate change is more likely to be down than up, even though the Fed has not said so. Lending support to that view, however, are the Fed’s past actions when the yield curve has approached inversion.
In Chart 1 we show the yields for both a 10-year U.S. Treasury bond and a 3-month U.S. Treasury bill over the past 30 years. The red vertical bars on the chart show the timing of initial cuts in the federal funds rate. As shown, the Fed has typically lowered the federal funds rate when the yields on these two securities have approached one another.
The bond market’s expectation of a Fed rate cut explains why longer-term bond yields have continued to fall despite the stock market’s rosier view of the economy. Anticipation of a future rate cut has driven investors to lock in current rates by buying longer- maturity bonds. As investors have crowded into longer maturities, prices for those bonds have risen, thereby pushing yields lower.
Stock valuations have rebounded in part due to the bond market’s lower yields. Analysts typically reference bond yields when modeling stock valuations. If all else is equal, lower bond yields equate to higher stock valuations.
Moreover, the stock market has climbed on the view that an economic recession is unlikely if the Fed doesn’t raise rates further.
That view is supported by the fact that current short-term interest rate level, as measured by the federal funds real rate (which equals the federal funds rate minus core inflation) has not reached the restrictive levels associated with the start of past recessions. Chart 2 shows the federal funds real rate over the past 44 years. The real rate’s current level of 0.7% is only slightly restrictive and is well below the 3% plus levels reached prior to each of the past five U.S. recessions.
Having taken their cues from the Fed, the markets have voted on how they see the economy unfolding over the next year. The bond market is calling for the Fed to cut the federal funds rate, thereby pushing down yields on shorter-term bonds. The stock market is being supported by lower bond yields while forecasting continued economic growth. Those outlooks are complementary and they are priced into the markets. Now we wait to see the Fed’s next move.
1 As measured by the S&P 500 Index.
2 The federal funds rate is the interest banks charge to lend money to one another. The Federal Reserve adjusts the target federal funds raise to influence economic growth.