Bonds predict healthy economic growth and higher stock prices

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Interest rates are going up, and the way they are moving along different maturities suggests that the economy has virtually no chance of slowing down. In fact, it may be poised for acceleration, according to academics who have studied the behavior of the yield curve. If they are correct, this bodes well for further equity gains, even after the massive rally of the last few years.

US stocks have performed very well since the panicky days of early 2009, especially considering the lack of investor interest after the financial crisis. As we reported many times, the outstanding recovery of US equity prices happened despite hundreds of billions of dollars of stock mutual fund liquidations that were reinvested in bonds.

But this is not what investors are doing anymore. After an interest rate rally that ended with the lowest US Treasury rates on record, bonds are now falling out of favor. As a result, bond mutual funds are losing assets at a rapid clip while stock funds are enjoying their largest inflows in years.

So, despite the huge gains in equity prices, analysts suspect that stocks can go even higher because of this "great rotation" - a wave of bond sales and equity purchases. This, at first glance, makes sense: if stocks went up so far with little demand, then they should go up even more as investors start buying in size.

But other analysts are worried that this newly-found preference for stocks may not be justified by a US economy they see sputtering along at best. These skeptics argue that while the US does not appear to be heading to another crisis, a “new normal” of low growth has set in that will prevent the economy to generate the kind of returns supportive of higher stock prices. They point to still-elevated levels of unemployment, relatively low GDP growth rates, and high levels of non-performing loans, among other factors, to make their case. They think that the sluggish economy will lead to lackluster corporate results, which means that stocks may have gone up too far on unfounded optimism. Further gains, therefore, may be unwarranted.

One place to look for clues about the future of the US economy is the yield curve of US Treasury bonds, which is a simple plot of bond rates along a maturity scale. The yield curve is “steep” when rates for bonds maturing far in the future are higher than rates for bonds that mature relatively soon. The yield curve is “flat” when rates are about the same across all maturities. A rare condition is an “inverted” yield curve, which happens when long-term rates are lower than short-term rates.

Since the 1980s economists have observed that flat or inverted yield curves often precede economic slumps. Because recessions usually cause stock markets to fall, there was great interest in developing models that use the yield curve to estimate the probability of upcoming recessions.

Why is the difference between long- and short-term rates related to economic activity? Because a stronger economy is associated with higher inflation, which causes longer-term interest rates to go up. On the other hand, an economy expected to decelerate brings down future inflation, and longer-term rates decline. So the shape of the yield curve is a proxy for how the market views future economic prospects.

What is the yield curve saying now? The yield curve is hovering around fairly steep levels, suggesting not only that chances for an economic slowdown are minimal but also that the economy may be poised for faster growth.

It is not difficult to find economic indicators that support this forecast, in spite of the skeptics. US exports have reached record-highs, the labor market has improved steadily, and budget deficit projections have been falling for months. With high levels of corporate profits and vastly improved personal balance sheets, the steep yield curve may indeed be pointing to stronger economic activity in the quarters ahead.

Graph: Probability of a recession according to the New York Fed - http://www.pathfinancial.net/Newsletter/images/130808-01.gif

For many years the Federal Reserve Bank of New York has calculated the probability that the US will be in recession a year later using the difference between the US 10-year Treasury rate and the 3-month T-bill rate. This model has been quite effective at predicting recessions, as the graph shows. According to this, the probability that the US will be in recession in the next 12 months is virtually zero.

Can we trust this model? To quote a paper by the Federal Reserve Bank of New York,

“The consistency with which these explanations relate a yield curve flattening to slower real activity provides some assurance that the indicator is valid. Nevertheless, in the end, we must remind ourselves that the evidence of the yield curve’s predictive power is statistical and that, however accurate past signals have been, it is impossible to guarantee future results.” (The Yield Curve as a Leading Indicator: Some Practical Issues - Current Issues of Economics and Finance, July/August 2006)

This is good advice. Both the 10-year US Treasury bond and the 3-month T-bill rates have been profoundly influenced by the Fed’s “extraordinary” monetary measures, which anchored short-term rates at virtually zero for years and have focus heavily on the 10-year note for official buying and selling. It is therefore conceivable that the Fed’s interventions have taken away at least some of the predictive ability of this model.

Graph: US stock prices and the yield curve - http://www.pathfinancial.net/Newsletter/images/130808-02.gif

But if we look at the difference between the US 30-year bond and the US 3-year note rates – two points that may be less directly affected by the Fed’s actions – we arrive at the same conclusion: according to the yield curve, the economy poses no impediment for the stock market to be at higher levels in the months ahead (see graph). Just as the flat or inverted yield curve flashed bright warning signs before the market crashed in 2000 and in 2008, today’s far steeper levels suggest no threats to the stock market in the foreseeable future.

Summer is a tricky time for stocks, and the prospect of yet another unproductive fiscal battle in Congress is growing. On top of that, the Fed’s “tapering” plans are unclear. Therefore, higher volatility for stocks is quite likely in the short term. The challenge for investors will be to hang on and plough through it. The longer-term outlook for stocks, as told by bonds today, looks as bright as one could hope for.

What now?

We use quantitative measures to build and maintain dynamical multi-asset portfolios for our clients. Our process aims to identify when to buy or sell different asset classes, with a focus on avoiding extended losses and see through the haze of very short-term volatility. Please send us a request for a copy of a whitepaper describing our investment process, or contact us if you would like to know more about how Path Financial’s investment processes works. We’ll be happy to set up a confidential meeting to discuss new paths to financial success. Read more