Stocks are at record highs, the job market is booming and fears about China’s deadly coronavirus have eased on Wall Street. The bond market, however, is again flashing a potential warning signal for the global economy.
A sharp rally in Treasurys in recent weeks led parts of the U.S. yield curve to invert, a signal that is often a harbinger of a recession. An inverted yield curve happens when shorter-term bond yields climb above longer-term ones. Investors flocked to safe-haven assets like Treasurys recently on fears that the virus could hinder global growth, sending long-term yields lower.
That’s left some investors scratching their heads as the American consumer—the pillar of the U.S. economy—remains strong while the U.S. economy is in the midst of its longest expansion on record.
“It seems like the stock market is a step behind in realizing the potential for slowing growth in the coming months,” says Gregory Daco, chief U.S. economist at Oxford Economics. “In reality, very few people are exposed to the coronavirus in the U.S., yet the uncertainty of the outbreak and the potential ramifications it could have on the stock market would still have a direct consequence to average households.”
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A tale of two markets
The stock and bond markets have been at odds with each other in recent months, telling two different stories about the outlook for growth ahead. The Dow Jones industrial average is trading at all-time highs, a sign that stock investors are pouring money into shares under the belief that the U.S. will shake off challenges from the virus if it’s contained.
But the bond market still foresees risks on the horizon that could slow the economy. The recent drop in yields was driven by the coronavirus, but yields were already low because of other factors including concerns about a sluggish global economy and lingering trade worries.
So which one is right? One possible theory is that both are forecasting a similar story, analysts say..
Investors adjust bets
Bond investors are likely adjusting their expectations to reflect low inflation and what the Federal Reserve will do next with interest rates, experts say. Yields on shorter-term bonds are sensitive to changes in central bank policy while longer-term bonds are more vulnerable to changes in inflation expectations.
“I think the stock and bond markets are actually telling the same story,” says Jim Paulsen, chief market strategist at the Leuthold Group. “That message is that inflation is weak but economic growth is still healthy.”
The Fed cut rates three times last year to cushion the economy against a slowdown in business investment and the possibility of recession. And expectations have risen recently that the central bank could lower borrowing costs again later this year.
Federal-funds futures, used by investors to place bets on the course of central-bank policy, showed a 42% chance of at least one interest-rate cut by June, double the probability from just a month ago, according to the CME Group’s FedWatch Tool.
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Recession risks remain low
Recession odds remain low since stocks remain at records and jobless claims are low, according to Bruce Bittles, chief investment strategist at R.W. Baird. He favors the “60-40” rule for investors looking to diversify their portfolio, which means 60% of a portfolio is in stocks and 40% in bonds.
Stock investors are betting that the Fed will step in and lower borrowing costs to help shield the U.S. economy if global risks increase in the coming months, Bittles explains. Low rates also tend to drive investments to riskier assets, such as stocks.
“If the stock market starts to falter, we’d be more inclined to believe that the global economy would be impacted by the virus, but it’s still too early to say,” Bittles says.
Strong job creation and firming wage growth in January helped reassure investors that the economic expansion still has legs despite virus-induced fears of an economic slump.
To be sure, there’s another worrisome sign: oil prices slumped into a bear market recently on growing concern that the coronavirus will disrupt the world’s second-largest economy. Copper, which is also sensitive to global growth, has taken a hit this year.
“If oil and copper continues to fall, the message there is that the global economy is set to take a pretty good hit because of the virus issues in China,” Bittles says.