US stocks reacted to Trump's presidency with euphoria. The Dow Jones Industrial Average grew by 25% in 2017, becoming one of the most efficient global asset classes.
With the US Treasury, the situation was different: the yield on 10-year bonds fell slightly from 2.44% at the end of 2016 to 2.41% in 2017. And the yield spread between 2-year and 10-year bonds, often a slowdown signal growth or the upcoming recession, fell from 125 b. p. to 51.8 bp n. at the end of 2017.
Bonds, not stocks, have become the best indicator of two recessions in the 21st century. When receiving various messages from stock and bond markets, investors should pay particular attention to the bond market in deciding on the allocation of assets in 2018. Treasury was the best indicator of two recessions in the 21st century. The first lasted from March to November 2001, the second from December 2007 to June 2009.
In the latter case, yields fell for several months before the recession, while stocks remained strong in the first half of 2008, despite the fact that the economy was already in recession.
There is every reason to believe that the Treasury is now making a warning.
A sense of caution in the bond market in 2017 was not caused by the successful adoption of the tax bill. Although the yield on 10-year bonds rose to almost 2.5% on December 20, when it became clear that the bill would be passed, it subsequently fell, closing the month with minor changes.
The increase in shares is due to the situation with corporate incomes that exceeded consensus estimates in recent quarters and later a reduction in corporate tax rates from 35% to 21%. Nevertheless, a decline in bond yields suggests that stock growth may not be accompanied by rapid economic growth or a significant increase in inflation.
The narrower spreads between 2-year and 10-year treasury bonds also reflect the idea that the Fed’s stated goal of raising the rate three times in 2018 may not be fulfilled.
If the economy slows down significantly after the initial surge of optimism amid tax cuts, the 10-year yield is likely to fall even more when the 2-year yield grows amid a tightening of the Fed, which will ultimately lead to an inversion of the yield curve. And the inversion of the yield curve was a harbinger of recessions in 2001 and 2007-2009.
And if recessions were always preceded by a negative spread of 2-year and 10-year returns, then a negative spread did not always end with a recession. For example, the inversion of the yield curve in May-June 1998 did not prevent the growth of GDP under conditions adjusted for inflation by more than 3% in 1999 and in the first half of 2000.
This has led some market observers to suggest that a potential negative spread should not be a concern. And there are a number of reasons to disagree with this point of view.
Firstly, wage growth remains sluggish despite a fivefold increase in the Fed's balance sheet after the financial crisis and still low interest rates almost 10 years later. This cannot be offset by recent tax reform.
Institutions such as the U.S. Congressional Budget Office have estimated that the benefits of tax cuts will come first and foremost to high-income individuals who are not major consumers. Consumption accounts for about two-thirds of US GDP.
Secondly, the new rules imply a reduction in government spending on the health system. This will reduce consumption among low-income and older Americans, even if lower tax rates are designed to increase spending.
Thirdly, the acceleration of economic growth depends on companies that respond to lower corporate tax rates by hiring more workers and raising their salaries.
Global competition from low-cost producers will limit the ability of US companies to achieve these goals, and stock repurchases and increased dividends will be the most likely outcome. This is why the recent rise in stock prices is a logical outcome, even if inflation expectations remain low, resulting in lower bond yields.
In general, investors should be especially careful about messages from bond markets. Stock growth will not last long if bond yields and the economy do not interact.