Bond Market vs. Stock Market: Decoding the Divergence in U.S. Economic Outlook
By Jamie McGeever
ORLANDO, Florida (Multibagger) - Bond investors traditionally hold a pessimistic view while equity investors are naturally optimistic. However, the growing divide between these two camps' perspectives on the U.S. economy and anticipated interest rate cuts is more complex than this market maxim suggests.
The Bond Market's Gloomy Forecast
Current rates markets are pricing in an aggressive Federal Reserve easing cycle, historically aligned with severe market shocks, recessions, or both. Wall Street, on the other hand, maintains equity prices near all-time highs and operates on the expectation of a 15% growth in earnings next year.
This discrepancy raises questions.
The Bond Market's Track Record
While the bond market is often seen as a more reliable indicator of economic and monetary policy trends than the stock market, it has frequently been off the mark. Historically, it has underestimated the resilience of the U.S. economy and prematurely predicted the onset of the Fed's easing cycle.
Rates futures are currently pricing in nearly 100 basis points of cuts over the Fed's remaining three policy meetings this year, 150 bps by March, and 200 bps by September next year. The negative spread between the fed funds rate and the two-year Treasury yield is at historic levels.
This level of implied easing mirrors the conditions seen during the early 1990s recession, the dotcom crash, the Global Financial Crisis, and the COVID-19 pandemic, according to Bob Elliott, CEO of Unlimited Funds and a former Bridgewater executive.
"Current pricing of cuts this quickly is in line with the depths of past recessions or crises, not stocks basically at all-time highs," Elliott states.
Even though U.S. rates futures markets have stabilized since the volatility shock on August 5, they still assign a one-in-four chance to the Fed cutting rates by 50 bps at its September meeting. Historically, the Fed has only commenced an easing cycle with a half-point cut in response to severe market stress.
The Stock Market's Optimistic Outlook
Conversely, stocks are not priced for a recession.
Despite a recent correction driven by the unwinding of crowded trades, a selloff in Big Tech mega caps, and a significant volatility shock, stocks have made a remarkable recovery. The S&P 500 is now within 1% of July's record peak.
Nvidia (NASDAQ: NVDA), a symbol of the AI-driven future, has rebounded 43% in just two weeks.
Equity investors are not only bullish on Big Tech. The second-quarter earnings season shows a remarkable 13.4% year-over-year profit growth for S&P 500 companies, up by 5.1 percentage points from initial estimates. Nine of the 11 sectors posted increased profits.
The consensus estimate for aggregate S&P 500 earnings growth next year is 15.2%, according to LSEG/Refinitiv data, with all sectors expected to show earnings growth. This optimism partly hinges on expectations of a lower discount rate, but the outlook for consumers and corporate profits is also robust.
Who's Right: The Bond Market or the Stock Market?
So what is the bond market seeing that the stock market is missing?
Some argue that this divergence can be explained by examining the real – or inflation-adjusted – federal funds rate and changes to the so-called R-star, the Fed's estimate of the long-run neutral rate of interest. As inflation has cooled, the real fed funds rate has risen to nearly 3%, the highest since 2007.
The Fed's R-star estimate is 2.8%, suggesting the policy rate could be cut by 250 basis points and still be restrictive. Thus, significant rate cuts may not necessarily signal a recession or crisis.
However, considering the modest unemployment rate, healthy economic growth, and narrow credit spreads for investment- and junk-rated firms, it’s hard to argue that policy is overly tight.
Breaking It Down: What Does This Mean for You?
In simple terms, the bond market is signaling a high chance of economic trouble ahead, anticipating aggressive interest rate cuts similar to past crises. Conversely, the stock market remains optimistic, expecting strong earnings growth and a resilient economy.
Impact on Your Finances:
- Investments: If the bond market is correct, we could see a recession, impacting stock prices and potentially leading to lower investment returns. If the stock market is right, continued growth could mean higher returns on your investments.
- Interest Rates: Anticipated rate cuts could lower borrowing costs for mortgages, loans, and credit, making it cheaper to borrow money.
- Economic Outlook: Understanding these market signals can help you make more informed financial decisions, whether it's adjusting your investment strategy or planning for potential economic changes.
Ultimately, while the bond market has traditionally been right, this time might be different. Keep an eye on both markets to better navigate your financial future.
Disclaimer: The opinions expressed are those of the author, a columnist for Multibagger.