Diverging views on stocks, bonds at Fed turn into chasm: McGeever | WSAU News/Talk 550 AM 99.9 FM

By Jamie McGeever

ORLANDO, Florida (Reuters) – Bond investors are by nature pessimists and stock investors are by nature optimists. But that market maxim doesn’t fully explain the seemingly wide gulf that has developed between the two camps’ views on the U.S. economy and looming interest-rate cuts.

Interest-rate markets are currently pricing in an aggressive cycle of easing by the Fed, historically consistent with deep market shocks, recessions, or both. Meanwhile, Wall Street continues to hold stocks near record levels and trades on expectations that earnings growth will exceed 15% next year.

Something is not right here.

HALF EMPTY?

The bond market is often considered a more reliable weather indicator for economic and monetary policy than the stock market, but the former has been making a mistake for years. It has consistently underestimated the resilience of the U.S. economy and repeatedly prematurely called the Fed’s easing cycle.

Interest rate futures are pricing in nearly 100 basis points of cuts over the Fed’s remaining three scheduled meetings this year, 150 basis points through March and 200 basis points through September of next year. The negative spread between the federal funds rate and the yield on the two-year Treasury note is at historic levels.

This degree of alleged monetary easing is consistent with the early 1990s recession, the dot-com bust, the global financial crisis and the COVID-19 pandemic, said Bob Elliot, CEO of Unlimited Funds and former CEO of hedge fund giant Bridgewater.

“The current prices for such rapid cuts reflect the depth of previous recessions and crises, not the level of action, which is essentially the highest it has been in history,” Elliott says.

And while U.S. interest rate futures markets have calmed considerably since the Aug. 5 volatility shock, there is still a one-in-four chance the Fed will cut rates by 50 basis points at its September meeting.

The only times in the modern era that the Fed began an easing cycle with a half-percentage-point cut were in January 2001, September 2007, and October 2008. Two of those moves were emergency actions, and the third followed a pair of Fed conference calls discussing what were then signs of serious market stress.

OR HALFWAY?

Meanwhile, stock prices certainly do not reflect the recession.

After a recent correction fueled by the unwinding of several crowded trades, a sell-off in Big Tech megacaps and a sharp volatility shock, stocks have made a remarkable recovery. The S&P 500 is now within 1 percent of its record high set in July.

For example, shares of Nvidia, the magic dust symbol of the future of artificial intelligence, are up 43% in just two weeks.

It’s not just Big Tech that stock market investors are looking to. The second-quarter earnings season, which is coming to a close, shows that S&P 500 earnings are up 13.4% year over year, 5.1 percentage points above estimates from the start of the season. Nine of the 11 sectors saw earnings rise.

And the consensus estimate for S&P 500 total earnings growth next year is even higher, at 15.2%, according to LSEG/Refinitiv data, with every sector expecting earnings growth. Some of the market optimism is undoubtedly based on expectations of a lower discount rate, but the outlook for consumers and corporate earnings is not as bleak.

IS THE STOCK EXCHANGE RIGHT?

So what does the bond market see that the stock market doesn’t?

One could argue that this discrepancy is a mirage that can be explained by looking at the actual — or inflation-adjusted — federal funds rate and changes in the so-called R-star, the Fed’s estimate of a long-term neutral interest rate that neither stimulates nor depresses economic activity.

As inflation has fallen over the past year, the monetary policy target range has remained stable at 5.25% to 5.50%, pushing real federal funds up to almost 3%, the highest level since 2007.

The Fed’s R-star estimate is 2.8%, meaning the policy rate could be cut by 250 basis points and still be considered “tight.” So maybe significant rate cuts don’t have to be tied to a recession or crisis?

But when you factor in the still-moderate unemployment rate, relatively healthy economic growth, and tight credit spreads for investment-grade and junk-rated companies, it’s hard to deny that the policy is all that restrictive.

So maybe this is another example of why the rules of the past simply don’t apply when trying to assess today’s economy. Regardless, the stock market seems to be on firmer ground.

“You look at earnings and it doesn’t look like we’re in a recession,” says Callie Cox, chief market strategist at Ritholtz Wealth Management. “I would trust the stock market in that scenario. The stock market is right—the economy is still in good shape.”

Usually the bond market is right. But maybe this time it really is different.

(The views expressed in this article are those of the author, a Reuters columnist.)

(This article has been retabled to correct the title of the post in paragraph 27)

(Text: Jamie McGeever; Editing: David Holmes)