The Bond Market And The Stock Market Can't Both Be Right

|
Includes: BBSA, BIL, BNDX, BWX, CLTL, DFVL, DFVS, DIAL, DLBL-OLD, DLBS, DTUL, DTUS, DTYL, DTYS, EDV, EGF, FIBR, FIXD, FLIA, GBIL, GIM, GLBY, GOVT, GSY, HYDD, IEF, IEI, IGOV, ITE, OPER, PLW, PST, RISE, SCHO, SCHR, SHV, SHY, SPTL, SPTS, TAPR, TBF, TBT, TBX, TLH, TLT, TMF, TMV, TTT, TUZ, TYBS, TYD, TYNS, TYO, UBT, UST, USTB, VGIT, VGLT, VGSH, VUSTX, ZROZ
by: Desmond Lachman
Summary

Global bond markets are behaving as if major trouble lies ahead for the US and global economies.

Global stock markets are behaving as if the economic skies will remain forever blue. The US equity markets are repeatedly hitting new record levels and are trading at elevated valuations.

Which financial market proves to have been the better economic forecaster will have a great bearing on the future course of the US and world economies.

There are few things about financial markets about which one can be certain. However, there could be an exception today when there is such a discrepancy between the gloomy government bond market and the optimistic equity market's view as to where the US and world economies might be headed. In the period ahead, both markets cannot possibly be proved to have been correct in their economic forecast at the same time.

Global bond markets are behaving as if major trouble lies ahead for the US and global economies.

One indication of this dismal view is the fact that US 10-year Treasury yields have dropped to below 2% and are now well below the Federal Reserve's short-term policy rate of 2.4%. This so-called inversion of the yield curve tells us that US government bond market participants are thinking that the US is heading for an economic recession that will force the Federal Reserve to cut interest rates several times in the year ahead.

Another bond market indication that real trouble might lie ahead for the world economy is the fact that a record $13 trillion of global sovereign bonds are now trading with negative interest rates. Negative interest rate bonds now account for around half of all European government bonds. In Germany, for example, one has to pay around 0.4% a year for the privilege to lend interest free to the German government over a 10-year period.

These negative bond yields imply that global bond market participants apparently believe that the world economy will be in such a poor state as to keep world inflation and world interest rates unusually low for a prolonged period of time.

While bond markets might be fretting about the US and world economic outlook, global stock markets clearly do not share that view and are behaving as if the economic skies will remain forever blue. A clear indication of this exuberance is the fact that the US equity markets are repeatedly hitting new record levels and are trading at elevated valuations that have only been experienced three times in the last one hundred years. This would seem to imply that they expect that the longest US economic recovery in history will continue apace indefinitely.

Which financial market proves to have been the better economic forecaster will have a great bearing on the future course of the US and world economies. If the equity markets are correct, the global economic recovery will likely continue for some time to come. However, if the sovereign bond markets are correct, large losses could be incurred by holders of equities and of credit risk products who are not pricing in any trouble ahead. That, in turn, could make for a deep economic recession, as it likely would entail real financial market stress.

An inverted yield curve has been an accurate early warning signal of each of the last nine US economic recessions. Considering that the bond market has generally been a better economic forecaster than the stock market, economic policymakers would be well advised to pay close attention to what the US and global government bond markets are trying to tell them.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.