Stocks and Bonds Are Sending Mixed Economic Signals

Something interesting, unpredicted and possibly worrisome is occurring on financial markets. Stocks and bonds are sending mixed - and conceivably contradictory - signals on the economic outlook. Stocks are routinely setting records, suggesting a recovery that's on track and strengthening. Meanwhile, interest rates on bonds have dropped. One possible interpretation is that bond investors expect the economy to weaken, pulling down interest rates and inflation in the process. Both messages can't logically be correct.

Let's start with the numbers. In 2013, the U.S. stock market boomed. The Standard & Poor's index of 500 stocks increased 30 percent. Other indexes also enjoyed double-digit gains. Early in 2014, many portfolio managers and forecasters predicted declines. The "correction" was mild and short-lived. Stocks have hit new highs. Some foreign markets have also done well. Germany's market is up 4 percent in 2014 and 22 percent over the past year.

Meanwhile, bond interest rates have fallen. At the year's start, rates on a 10-year Treasury bond were about 3 percent; they dropped to 2.5 percent, though they've edged up recently. For many economists, this was a shock; they had expected rate increases. The economic recovery would put upward pressure on rates. In addition, the Federal Reserve was reducing its bond-buying, a process known as "tapering." This, too, would raise rates. Not so. Interestingly, European rates have also declined. Rates on 10-year Spanish bonds (2.7 percent) and Italian bonds (2.8 percent) are near U.S. Treasury bond rates.

What gives?

For the record, none of this has changed most economists' view of 2014. In January, they expected an improving economy; they still do. The first quarter's poor performance (gross domestic product down 1 percent at an annual rate) is blamed on bad weather. Economic growth will average 3 percent or more through at least 2015, according to the median response of 47 forecasters surveyed by the National Association for Business Economics (NABE). Consumer spending, housing construction and business investment will expand. The unemployment rate, 6.3 percent in May, will drop to 5.8 percent by year-end 2015.

All this is consistent with slowly rising stocks. In fact, that's what the NABE economists predict: a 6 percent market gain in 2014 from the end of 2013, paralleling the expected increase in after-tax corporate profits. (Note, however, that this implies most of the market's annual gain has already occurred. Through June 12, the S&P index of 500 stocks was up 4.4 percent in 2014.) But this relatively rosy outlook may be inconsistent with falling interest rates. In a strengthening recovery, they would typically rise.

Many economists don't sound worried. Mark Zandi of Moody's Analytics doubts the bond market is warning of a weaker economy. If bond investors were fearful, he says, the so-called spread between interest rates on "junk bonds" - issued by weaker firms - and interest rates on high-quality corporate bonds would be widening. The reason: In a weaker economy, junk bonds would be riskier. But, he says, the spreads are narrowing.

Zandi attributes the fall in bond rates to a recent proposal by the Federal Reserve requiring banks to hold more "liquid assets" as a way of defusing future financial crises. Liquid assets consist of cash plus securities that can be sold quickly to raise cash. U.S. Treasury securities - because they are backed by the government - play this role. But banks underestimated the amount of Treasury securities they would need, says Zandi. So banks have been buying Treasuries; this lowers their interest rate.

Economist Sara Johnson of IHS Global Insight also is skeptical that low rates signal dangers to the global recovery. Even a slump in China, she says, would not tip the world into recession. She notes that both the Fed and the European Central Bank have worked to reduce rates. Bond investors may also have concluded that inflation will remain low indefinitely; this would dampen rates. Whatever the cause, she adds, "stock markets like low interest rates."

The verdict: an invigorated recovery. The stock market's optimism trumps the bond market's (possible) doubt. Or does it? Could the economy disappoint again?

Post-crisis economic commentary has consistently misjudged the outlook. It has underestimated the crisis's psychological effects on consumers and business managers. The past is less a guide to the future because the financial crisis and Great Recession are, in living memory, unique events. That's why the economy remains an enigma.