Unless you believe the Federal Reserve will ease monetary policy, which I don’t, it is getting harder to reconcile what are still historically low bond yields and relatively high stock prices. More consistent and sustainable levels probably lie somewhere in the middle. Exactly where, as well as when and how we would get there, depends primarily on the balance between geopolitical and economic-policy influences.
Stock markets repeatedly have proven extremely resilient in shrugging off both political and geopolitical worries. In doing so, they have relied on deeply anchored market beliefs regarding stable growth, supportive central banks and further liquidity injections. As a result, they view the prospects for stronger corporate earnings and economic growth as compensations for geopolitical fluidity.
The same isn’t true of government bond markets. There, yields on 10-year Treasuries have languished recently below the 2.30–2.60 per cent range that was established after the November presidential elections as geopolitical worries have been compounded by concerns about both low inflation and subdued growth.
This is not the first time that government bonds and stocks have sent conflicting signals, and it won’t be the last. Moreover, this inconsistency coexists with several others, including the divergence between emboldened measures of business/consumer confidence and hard data that remains sluggish.
Also, let us not forget the asymmetrical upside/downside prospects. Simply put, at current levels, stocks heavily dominate bonds when it comes to most current assessments of the upside return potential segment.
Yet this particular market inconsistency has persisted for some time, and it has outlasted many explanations, including those emphasizing the technical positioning of markets. Indeed, the only proper way to reconcile the two competing market signals at this stage is through a forecast of renewed monetary policy easing on the part of the Federal Reserve.
Absent a major economic downturn that would also rout stock markets, such easing is highly unlikely. Indeed, while the balance of risk may be shifting, the baseline still favours two additional interest rate hikes this year, together with an action plan for balance-sheet normalization.
The more likely outcome is a reconciliation of market signals with government bond yields moving up and stock prices down. When this happens, where the two settle, and the orderliness of the process will be mainly a function of two influences: the extent to which geopolitics has an adverse effect on the outlook for growth, and the extent to which U.S. policy reforms improve the prospects for actual and potential growth. In the meantime, investors should be increasingly wary about betting on durable market inconsistencies.
Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”Report Typo/Error