Stocks & Treasuries Are Living In Separate Worlds

The stock market and the bond market are in two separate worlds. Ever since the March bottom at 2.64%, the ten-year bond has been rallying. The selloff after the all-time low in yields in the summer of 2016 didn’t even get the yield to have a higher high. The downtrend in yields is still intact. The U.S. Macro Surprise index crash seems to be pushing bond yields lower even though stocks are still at their all-time high. Besides weak economic data, the ten-year bond is rallying because inflation expectations are falling. As you can see in the chart below, the 10-year breakeven inflation rate has fallen from 2.08% in January to 1.79%. The potential wage inflation isn’t showing up in the overall numbers. The fact that wage inflation isn’t pushing up overall inflation is a great sign because it means real wages are rising. The Fed doesn’t see this streak having staying power, so it’s raising rates next week.

An alternative theory on monetary policy is that the Fed is raising rates because the stock market is allowing it to. The Fed doesn’t like being near the zero bound because there’s no room to cut rates if a recession hits. Since rate hikes usually cause recessions, this is a catch-22. In that case, you may be wondering why the Fed doesn’t always keep rates low. The risk is debt bubble creation. In the next recession, we’ll see the negative consequences of such action since the Fed experimented with that policy in this cycle.

The cratering 10-year bond yield, which is now at 2.1330% has caused the 10-2 spread to fall to 85 basis points. I have said that a correction in the stock market would occur if the spread fell below the cycle low of 75 basis points. So far, there’s been little action in equities as the S&P 500 is less than 1% off its all-time high. In 2016, global central banks expanded their balance sheets to stave off a recession. That plunged fixed income yields into a new world order where negative yields became more popular than ever. Negative yields went from an impossibility to a large portion of the market in a few years.

Now with central banks about to start unwinding their balance sheets, interest rates are falling again which is counter-intuitive. The chart below shows the latest matrix of government bond yields. The 10 year German bund yield has fallen from 43 basis points to 25 basis points in the past few weeks which is surprising given the great economic reports in Europe. The U.S. appears to be leading the world lower this time. With the central banks unwinding their balance sheets, I wouldn’t say that negative yields are being caused by the free market. Firstly, the unwind is still in its early innings. The market may be anticipating future bond buying caused by economic weakness in a few years. The central banks getting out of the market doesn’t end their effect on bonds because it’s implied there will be future action if the necessity arises.

At face value, the stock market is ignoring the U.S. Macro Surprise index. But the indexes don’t tell the whole story. As you can see from the chart below, the rotation out of U.S. ETFs is the fastest in 2 years. International ETFs are the recipient of this new money. In this bull market, up is the new down as American stocks haven’t sold off on this change in asset allocation; it’s just not up as much as it would be if it was receiving flows. So far, I’ve been wrong in my assertion that this change in allocation would hurt equities, but if it continues it’s clearly a headwind for stocks.

The negative economic reports and falling inflation make the Fed look silly for hiking rates, but that’s not the whole picture. The Fed is threading a needle, hoping it can raise rates in the anticipation of wage inflation without disrupting the economy. Rate hike cycles have led to a recession all but 3 times, but by the time there’s a recession the Fed is hoping it will get close to normal rates. One important economic metric which is showing the Fed is in good shape with rate hikes is shown in the chart below. Tax withholdings in May 2017 are up 6.25% year over year. This shows that workers are getting paid more somehow. Either they are working longer hours, earning more per hour, or more people have jobs. Both the BLS report and the Atlanta Fed’s wage tracker are surveys. As accurate as the Atlanta Fed’s survey tries to be, the hard data tells the unfiltered truth. One issue with hard data which isn’t seasonally adjusted is it can be marred by one-time events. As you can see, the long-term trend is positive which shows that fear is misguided. Also, if you use year over year stats, you don’t have to worry about seasonality.

The chart below shows the strength in the labor market which is leading to the increase in tax withholdings. The NIFIB small businesses index is showing that small businesses have more jobs to fill than ever before. The JOLTS is showing there is record new job openings. There is a clear divergence between the labor market and the macro surprise index. There’s a possibility that the economy is starting to roll over. If that’s the case then, it’s not surprising to see the labor market lag because it’s a late cycle indicator. On the other hand, even though the yield spread is waving a caution flag, the Macro Surprise index is much lower than it should be. In the last cycle, the 10-2 year spread was at 85 basis points in early 2005 which was about 22 months before the recession.

Conclusion

There are three indicators showing different economic forecasts. The labor market shows everything is great. The yield curve shows there could be a recession in the intermediate term. The Macro Surprise index shows the economy could be close to a recession. I’m siding with the yield curve because it has a great track record of economic forecasting. The economic surprise index was lower in early 2016 than it is now, yet there was no recession. The yield curve was also flatter in 2016 than now, but it never went inverted meaning there was never a recession prediction

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