Equities have renewed their rally - and so have bonds, and that is creating much alarm among some investors. Whereas the former suggests the stage is set for solid growth, the latter and the accompanying narrowing of the yield curve raise red flags about the health of the economy. I am not sure there is much of a puzzle here. This dichotomy is fairly typical of a monetary tightening cycle and can exist for a long time. How long? Until the Federal Reserve finally snuffs out the expansion with excessively tight monetary policy.
Equity markets stumbled after the Fed's first rate hike in this cycle but subsequently grew in a remarkably average way:
Equity prices are pretty much exactly where you might expect based on the pattern of the previous six tightening cycles. Three of those - beginning in 1988, 1999, and 2004 - ultimately ended in recessions and substantial equity price declines. In each of those cases, the Fed tightened policy sufficiently to invert the yield curve:
The yield curve inversion occurred fairly swiftly after the tightening cycles of 1988 and 1999 began, whereas the process was longer for the 2004 cycle. The curve did not invert in the remaining cycles (it appears to have inverted after the 1986 hike cycle began, but this really overlaps with the 1988 cycle).
The curve today remains fairly steep relative to past cycles. Assuming past dynamics continue to hold, this suggests that a recession and a related drop in corporate earnings and equity prices are not on the immediate horizon. That further suggests that current worries about the divergence of stocks and bonds are overblown. Historically, equities rise even as the yield curve flattens in the wake of a tightening cycle. I see no reason to not expect the same this time.
That said, we can't rule out a severe correction in equity prices not associated with a recession. The 1987 crash clearly shows that possibility. But note that the surge in prices following the first rate hikes in 1986 was clearly an outlier. And with the help of a Fed rate cut, equity prices subsequently resumed a fairly typical trajectory as a recession was avoided. Given the lack of a similar surge in equity prices during this cycle, I don't think it is likely that we will see a sharp drop in equity prices that is not associated with a recession. Instead, declines of the type experienced in early 2016, historically moderate and short-lived, would be more likely.
The bigger immediate implication of the strong equity markets is that it likely induces a more significant monetary policy response. The Fed will likely interpret the combination of high stock prices and declining interest rates as indicative of loosening financial conditions. With the economy operating near its estimate of full employment, it will want to lean against those conditions. That means a rate hike in June with the expectation that more are to come.
It is the Fed's reaction to loosening financial conditions that eventually becomes cause for worry. In the past two cycles, the Fed continued to hike rates even after the yield curve inverted. In other words, typically, it is later in the tightening cycle that we should worry about the divergence between stocks and bonds. While past performance is no guarantee of future returns, the economy remains at a stage of the cycle where a flat or rising stock market is more likely than a sustained decline.