June 8, 2017

Dramatic tension

by Breakingviews.

U.S. equity investors are behaving as if it were the best of times, pushing stock indexes to new highs. Bond investors seem to believe a different tale, driving yields sharply lower even as a new Federal Reserve interest-rate hike looms.

Yields rose in tandem with equities in November and December, reflecting a shared hope that President-elect Donald Trump would juice growth and inflation with tax cuts, deregulation and infrastructure spending. The narrative has changed, though, as Trump’s stumbling effort to repeal his predecessor’s healthcare law and investigations into his campaign’s links with Russia have stymied his agenda.

Since peaking at just over 2.6 percent in early March, the yield on the U.S. Treasury’s 10-year bond has tumbled to 2.17 percent, the lowest since November. It has fallen despite the fact that the Federal Reserve has raised short-term rates twice and looks set to do so again next week. Yet equities have powered ahead, with the S&P 500 Index hitting a new record on June 2.

Both bulls and bears can find data to support their views. First-quarter GDP growth fell short of expectations, jobs growth has slowed and consumer-price inflation is back below 2 percent, all signs of relative economic weakness.

Meanwhile, first-quarter earnings at S&P 500 companies came in 14 percent higher than a year earlier, the strongest growth in more than five years. The OECD lifted its forecast for global growth to 3.5 percent on Wednesday, a trend which also provides a lift for stocks, given that the 500 largest U.S. corporations get nearly half their sales abroad.

If the bond market proves the better guide, stocks could fall as much as 20 percent, analysts and Bank of America Merrill Lynch reckon. If the economy remains on track, however, shares could continue going up while 10-year yields rise to 2.85 percent by year-end, tanking bond prices.

The tug-of-war is made harder to referee by flush investors’ search for returns at almost any price. The difference between yields on two-year and 10-year Treasuries tends to narrow when liquidity is abundant, and the gauge has dropped below 1 percentage point, a level last seen in the booms before the 2007-08 crisis and the tech collapse of 2000-01. Whether it’s caused by the reality of Fed action, further policy news, geopolitical worries or something else, it won’t be pretty when the two storylines converge.

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