The capital markets are always sending a message. Unfortunately,
the message’s meaning is generally only clearly understood in hindsight.
The added problem is that the capital markets can send mixed messages. The stock market and Treasury market are perfect examples right now of some mixed-up messaging.
Maybe, Just Maybe
The stock market is acting as if the economic expansion, now in its 117th month, is going to continue or even accelerate. The S&P 500 is up 10%, paced by the outperformance of cyclical sectors like industrials (+15.1%), energy (+13.1%), information technology (+13.0%), and consumer discretionary (+10.3%).
The Treasury market, on the other hand, is acting as if it expects the economic expansion to hit some speed bumps that could ultimately drive it off its expansion course. The 10-yr note yield, which one might think would be going through the roof based on how the stock market has started 2019, is down four basis points for the year at 2.64%.
The resilience of longer-dated Treasury securities has been baffling -- or perhaps what it really has been is telling.
Maybe, just maybe, the message of the Treasury market in hindsight is that inflation isn't going to get out of control because economic growth isn't going to get out of control.
That would be the case either because the U.S. economy isn't going to live up to the 3.0%+ GDP growth expectations espoused by administration officials or because the economy might underwhelm in a big way, maybe even slipping into a recession.
The timing of the ballyhooed recession is the great unknown, yet many are thinking this expansion, which is about to become the longest on record, is due to end soon as they witness a slowdown in global growth and the flattening of the Treasury yield curve.
This current expansion is a real geezer, too. In the 11 business cycles identified by the National Bureau of Economic Research between 1945 and 2009, the average length of time between a previous trough to a peak has been 58.4 months.
Economic expansions, however, don't die of old age. Recessions typically arrive on the back of a trigger point, like a commodity price shock, a credit event, or a spike in interest rates.
When the next recession happens, rest assured the National Bureau of Economic Research will tell you in hindsight when it started. The capital markets, though, are forward-looking, which is why the disparate showing of the stock and Treasury markets is generating a lot of debate in terms of what to expect for the economy in the months ahead.
One thing that history has shown is that a recession will drive down inflation, assuming it isn't sparked by a spike in oil prices.
That is an objective fact illustrated in the chart below.
The Federal Reserve is doing what it can to prolong the current expansion by backing away from the hawkish-minded policy stance it held throughout 2018. Now, the Federal Reserve is promising to be patient with its policy approach.
It is no coincidence that the 5-year, 5-year forward inflation expectation rate started to pick back up on January 4, which was the exact day Fed Chair Powell communicated the patient-minded message.
On January 3, the 5-year, 5-year forward inflation expectation rate hit a lowly 1.87%, having tracked there in conjunction with sliding oil and stock prices. This rate, which is a measure of expected inflation, on average, over the five-year period that begins five years from today, is now 2.03%.
What It All Means
That uptick inflation expectations has likely comforted the Fed, which does not want to see a collapse in inflation expectations. At the same time, it only leaves inflation expectations in-line with the Fed's longer-run inflation target of 2.0%. That's another reason why the Fed is willing to be patient right now with its policy approach, knowing there are risks on the horizon that could undermine growth prospects and shift inflation expectations lower again.
The Treasury market is cognizant of the risks; hence, the back end of the yield curve, which is most sensitive to inflation pressures, has been slow to adjust while the stock market has been rallying.
That's not to say the stock market isn't cognizant of the risks. It is, only it isn't accepting of the idea that the risks will come to fruition. That's the message at least that seems to be emanating from the stock market.
The message from the Treasury market has more conservative-minded undertones.
Why would that be?
We'll know clearly in hindsight, yet the assumed message today is that there hasn't been much movement in longer-dated Treasury yields because growth is expected to disappoint, which means there isn't any angst about inflation picking up, and maybe, just maybe, a budding expectation that disinflation will.