Which market will blink? Stocks or bonds?
Fed chairman Alan Greenspan has taken some heat out of the bond rally.
Speculation was rampant that the Fed was in the “eighth inning” of its credit-tightening cycle – an assertion made by Dallas Fed president Richard Fisher last month. Fisher’s statement had helped send the yield on the 10-year Treasury well below 4% two week ago as bond prices rallied.
But this past week, the benchmark yield went back above 4%. In his Congressional testimony, Greenspan recently said that the economy is on a firm footing and that rate hikes were likely to continue at a measured pace.
He also said inflation was contained, a view that was affirmed with Tuesday’s report on producer prices. Wholesale inflation fell 0.6% in May, the biggest drop in years. The bullish report on inflation might have reignited the rally in bonds, which thrive on low inflation. But Treasury prices rose only modestly after the report on the Property Price Index, which was based in large part on a fall in oil prices. That decline looks to have been temporary, now that crude oil is once again trading at over $55 a barrel, just a few dollars below its all-time high.
Stocks vs. bonds: rising together
Still, a mystery remains, says Philip Coggan in the Financial Times. Why have stocks and bonds generally been rising together since mid-April? It’s hard to see how the recent crop of data can be good news for both asset classes. Either the rise in unit labor costs and crude oil will lead to higher prices, implying an uptick in inflation and higher bond yields, or profit margins will absorb it, denting earnings and hence equities. The US economy is either robust enough to stomach further rate rises, which would dent bonds, or so weak the Fed will have to desist, which bodes ill for equities.
Bonds and stocks certainly can’t both be right, says Eric Fry in The Rude Awakening. And the mounting evidence of economic weakness suggests that “their intimate tango” will soon be over, with stocks falling back as the deterioration in the economy becomes increasingly clear. The U.S. Institute for Supply Management’s purchasing index of manufacturing activity has been dropping since early last year, and the ISM’s index of new orders has also been falling sharply.
Stocks vs. bonds: economic indicators
Another widely monitored data point, the Conference Board’s Index of Leading Economic Indicators, “has been slumping for months.” Note too that profit growth is slowing, with the rolling two-quarter earnings growth of S&P 500 companies down to 10% from 25% a year ago. Stock prices tend to track the earnings growth trend, so “at minimum, slowing earnings growth is not a good thing.”
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There’s also little evidence of the “renewed economic vitality” in the technology sector that the 20% bounce in the SOX index of semiconductor stocks suggests it is anticipating. Computer chip prices are at multiyear lows, and new orders for chips have fallen below the current sales rate.
The economy may be weakening because the stimuli of recent years have lost momentum, says Fry. As Comstock Partners notes, the tax cuts are over, cash-outs from mortgage refinancing are 75% below their peak, and consumers, whose debt relative to GDP is at record levels, have no savings left. Throw in historically high stock valuations and it adds up to “a market that has little reason to rise and a lot of reasons to fall.”
Goldman Sachs concurs that stocks and bonds can’t keep rising together, but predicts it will be the bond market that blinks, with prices coming under pressure and yields rising amid further Fed rate increases.
Even if slower growth prompts a pause in monetary tightening, the strength of the housing market argues against a rate cut anytime soon, says Lex in the FT. So equity investors’ recent optimism amid the prospect of an end to rate hikes and an eventual cut looks hard to justify.
Recommended further reading:
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