Removing the Monetary Stimulus Punch Bowl in Favor of Fiscal Stimulus Keg
Stock and bond markets have recently been characterized by a tug of war between investors who believe the economy is revving up and those who believe the slow-growth not no-growth trend remains locked in. U.S. stocks have hit a series of new highs before backing off slightly this week, while the bond market has been relatively resilient in the face of continued encouraging economic data that typically would send yields higher and prices falling. The 10-year Treasury’s yield has remained in a trading range of 2.30% to 2.60% since mid-November 2016.
So, why aren’t stocks and bonds on the same page?
In my view, the disconnect comes from investor uncertainty over how and when policymakers will transition from a period of monetary stimulus led by the Federal Reserve to fiscal stimulus led by government spending and regulatory changes.
President Trump outlined a policy agenda that includes corporate tax cuts, middle-class income-tax cuts and infrastructure spending, along with promises of continued regulatory reform and further job creation. Decidedly pro-business, this has encouraged risk-oriented equity market participants to drive prices to records on expectations of higher corporate earnings. But the bond market appears to be more skeptical.
Policy promises notwithstanding, U.S. economic data remains healthy, inflation has picked up a bit and the Fed continues to wrestle with the need for further increases to the fed funds rate. Currently, the probability of a 25-basis-point increase at the Fed’s Open Market Committee meeting next week has risen to 98%, up from just 40% two weeks ago. Investors and traders, reacting to the very strong ADP National Employment Report Wednesday morning, pushed the 10-year Treasury’s yield well over 2.50%—a level it hasn’t seen for more than two weeks.
In the coming weeks and months, investors will undoubtedly weigh the potential for fiscal stimulus and its impact on corporate earnings and GDP growth against the Fed’s continued gradual removal of monetary stimulus. Perhaps the bond market will eventually agree?
Bumps in the road should be expected. The stock market has incurred an average 14.3% intra-year decline in each of the last 30 years, and given the almost exclusively upward moves so far in 2017, it would not surprise me at all to see a drop of similar magnitude in the months ahead.
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