A tale of two markets: Stocks, bonds send mixed signals

So much for the idea that free financial markets are always rational. Today, at a time when the bond market is warning of a recession on the horizon, the stock market keeps trading at historically high valuations, suggesting that it believes blue economic skies continue to lie ahead.

Future market performance is hard to predict, but of one thing is certain: Both the bond market and the stock market cannot be right about their respective implicit economic forecasts given their diametrically opposite views on this issue.

Over the past 60 years, among the more reliable predictors of economic recessions has been the so-called yield curve inversion, which occurs when short-dated Treasury bond yields exceed long-dated Treasury bond yields. According to the Reserve Bank of San Francisco, since 1955 each time the yield curve inverted, an economic recession followed within six to 24 months.

Last week, the yield curve again inverted in the wake of Federal Reserve Chair Jerome Powell’s acknowledgement that inflation was proving to be longer-lasting than he had earlier thought and that the Fed might soon need to raise interest rates in 50 basis point increments to regain control over inflation. That announcement induced markets to send the two-year Treasury rate above the corresponding 10-year rate as it did on the eve of the COVID-19-induced recession in 2020.

The reason for today’s inverted yield curve is that the bond market apparently believes that the Fed will need to raise short-term interest rates substantially in order to get the inflation genie back into the bottle. At the same time, the bond market believes that the Fed will succeed in its anti-inflation battle. That is why the bond market is setting long-term interest rates at a level not far above the Fed’s 2 percent inflation target. It is doing so in the apparent belief that a recession will wring inflation out of the economy.

Evidently the stock market does not buy the bond market’s recession-on-the-horizon story. Indeed, even at a time of considerable geopolitical uncertainty from Russia’s invasion of Ukraine, the stock market keeps trading at very elevated valuations. According to the Shiller Cyclically Adjusted Price Earning’s Ratio (CAPE), today’s stock market valuations are around double their long-run average and at a level experienced only once before in the last 100 years.

That the stock market seems to be largely unfazed by a prospective Fed interest rate hiking cycle is more striking considering that today’s lofty equity valuations can be justified only on the assumption that ultra-low interest rates and satisfactory economic growth will continue indefinitely. But if the bond market proves to be right in its present forecast of higher short-term interest rates and an economic recession, both of the key assumptions underpinning the stock market’s presently high valuations will have proved to be mistaken.

It is also striking that the stock market is choosing to dismiss the bond market’s strong economic recession forecasting record at a time when consumer price inflation is already running at almost 8 percent and is bound to rise even higher on account of the Russian international oil and food price shock. One would think that this high inflation rate would dim the Fed’s prospects to succeed in wringing so much inflation out of the economy to meet its 2 percent inflation target without provoking a nasty economic recession.

Time will tell whether the bond market or the stock proves be the more accurate economic forecaster. Given the bond market’s strong past forecasting record and today’s very high inflation rate, I am not betting that the bond market is going to be wrong about a forthcoming economic recession.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.