A stark rally in stock prices came up in Q1 of 2019. Nonetheless, the bond market future moving simultaneously in the same period projects a 40% chance of Fed cut rates before December 2019. Since these different perspectives cannot be easily reconciled, the next few months should be interesting for the markets.
The Economic View
The Fed confirmed at its March meeting that the economic picture in the United States is mixed. Although inflation is stable and unemployment low, warning signs may be on the horizon with the recent inversion of the yield curve. Both industrial and construction production appear soft. Additionally, data and news from China and Europe presents risks.
On the contrary, the Fed’s concerns with regards to a weakening job market and softening retail sales appear overdone. That is majorly based on the latest data following to the Fed’s March meeting. It is normal for the economic outlook to appear uncertain. However, this time it is interesting due to the way bond and stock markets provide differing analyses of the economy.
The Bond Futures’ Take
Fed fund futures believe in a 40% chance of the Fed cutting rates at least one time before 2019 ends. That is a significant shift considering that in 2018 the market was debating otherwise. They were focused on the number of rate increases that they expected the Fed would make in 2019.
Currently, the focus has changed to how many cuts will happen and how fast the Fed will do it. The Fed only cuts rates when the economic picture darkens. This time it may be different with the Fed trying to repeal the over-enthusiastic hikes from the past 18 months. Nonetheless, history proves that the Fed cuts rates when the broader economy seems to be in trouble.
The bond market forecasts that the Fed will see worrying economic data in the near term prompting them to cut rates. Evidently, the current bond market futures data does not show adequate positive economic news to warrant a rate hike in 2019.
The Stock Market’s View
On the other hand, the stock market’s performance so far in 2019 is a contrast to the bond markets’ take. The Q1 rally of 2010 seems to be a reversal of the weakness of the last quarter of 2019. But, beyond the headlines, it is evident that the markets in 2019 are paced by gains for the consumer discretionary, I.T., and industrial sectors.
All these three sectors are cyclical and respond quite well to a growing economy. For instance, consumers will buy cars whenever they are economically secure. Also, businesses rarely embark on large I.T. projects in recessions. The bond market may be fixated on the prospects of a rate cut but the stock market currently seems to look through any weakness.
Furthermore, remember that the stock market at the moment is richly valued with the S&P 500 at 22x earnings. That is relatively high considering that the historical average hovers approximately 15x. Thus, the stock market appears relatively optimistic about the general economy.
Which Opinion Will Win?
Only time will tell as we await economic data to resolve the current tension existing between the bond and stock markets. If the Fed notes softer industrial production data, it may settle on the opinion that the more cyclical sectors will decline due to sluggish sales. Thus, it will eventually agree with the bond market’s view of events.
On the contrary, if the data in the Fed’s March meeting proves to be transitory, then the yield curve may lift. Also, the yield on the 10-year chart will rise back closer to 3% away from the current 2.6% level. If that happens, the Fed may move from the patient stance and point towards more rate hikes in future meetings.
In the past, the bond markets have proven to take a more stable and measured view of the economy. The stock market could be a more volatile indicator. Some of the economic concerns from March may have declined as the retail sales, job market, and China issues seem to have taken improvement trajectories.
Nonetheless, consumer confidence, industrial production, and the European economy seem concerning up to today. The economy still looks at how 2019 will play out. Either the stock prices will decline or the rates will rise for Treasuries in the coming months. A degree of both may also happen to reconcile the currently divergent perspectives from the bond markets’ pessimism and the stock markets’ optimism.