Interpreting the economy: which market is wrong ?

US equity and bond markets have performed in-line over the past few weeks. As a result, the correlation between 10-year rates and the S&P 500, which had turned positive since the announcement of Fed tapering (steepening rates and stronger equity markets), is now weakening once again.

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At this level of long-term rates, circumstances have become abnormal, signifying that one of the two markets is undoubtedly misinterpreting the situation.

Either equity markets are correctly indicating that US growth is probably soundly on track and certainly likely to accelerate. In this case, however, the output gap will soon narrow and forthcoming inflationary tension will oblige the Fed to tighten monetary policy, involving a hike in long-term rates.

Or alternatively, bond markets are providing a correct reading of the situation by indicating that growth is bound to level off, with the Fed adopting a wait-and-see attitude. In this case, US equities are clearly overpriced and a correction is highly likely in this market.

This leads to a multitude of implications, for the respective markets and also for potential trends within the equity asset class. As recent experience has shown, the sector rotation during the spring was particularly difficult to comprehend. The monetary guidance criteria used by the Fed to pilot the pace of QE tapering was initially based on unemployment alone, but now includes a whole range of indicators, thus decreasing the market’s ability to interpret the situation. Cyclical stocks have underperformed defensives as a result, whereas cyclicals had nonetheless been the market darlings when the Fed was implying a tougher stance in mid-2013.

It now seems more urgent than ever for the Fed to delay. Bond markets have accurately anticipated until now. But how can equity markets therefore remain bullish? The only possible explanation is that investors are anticipating global growth, which despite being sluggish, will be more evenly balanced across the geographical regions, amid very low inflation, with debt being progressively reduced and monetary policies remaining accommodating. These conditions constitute an ideal combination to underpin an indefinite equity market rally. We have to concede that this scenario is relatively unlikely however. Risky assets have already risen sharply on free money supplied by the central banks. Spanish 10-year yields are currently at the same level as US rates, with assets being increasingly allocated to carry trades.

It may be that we are moving inexorably closer to a correction in the market, which is misinterpreting the situation. It is therefore vital to remain vigilant regarding inflation in the US. There will be little change as long as inflation remains at the current level.

Franck Nicolas June 2014

Article also available in : English EN | français FR




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