Financial markets are experiencing a significant divergence in 2014 between the direction of stocks and bonds.
While the S&P 500 and Dow Jones Industrial Average have traded to new record highs, the yields on benchmark Treasury bonds have dropped sharply.
Normally, one would not expect stock prices to rise and bond yields to drop simultaneously because these movements suggest contradictory readings of the economy.
Higher stock prices indicate bullishness about economic growth, while lower bond yields suggest just the opposite.
However, the inconsistent signals being sent by markets are not as surprising as they seem, given the context of the post-crisis environment in which Federal Reserve policies have distorted normal market pricing mechanisms.
This situation could blindside investors who don't see it coming...Signs of Growth Are Appearing
Investors are being forced into riskier investments such as stocks and high-yield bonds in order to generate returns.
Investors have become confused about what constitutes risk.
They now believe that investments such as Treasurys and other government bonds, which offer miniscule nominal returns in a low-inflation environment and negative returns in a normalized or high-inflation environment, are low risk.
They are going to learn, to their detriment, that such investments are actually high-risk when central bank policies designed to suppress normal market functions fail to accomplish their goals, unleashing hyperinflation.
The latest government data shows that the U.S. economy shrank at an annual rate of -1.0% in the first quarter. Consensus estimates were much higher. While many observers are attributing slow first-quarter growth to bad weather, other factors contributed to poor economic performance.
Slower-than-expected inventory builds slowed growth by -1.6% in the period.
The good news is that this inventory drag should not recur in the second quarter. In addition, there are other signs that second-quarter growth should improve. Bank lending has been accelerating at a 9.5% annual rate over the past 17 weeks according to ISI Group.
One of the factors slowing post-crisis growth has been the trillions of dollars of dormant capital sitting on bank balance sheets; now that some of that capital is beginning to circulate in the economy, growth and inflation should pick up.
There are other signs that the economy is gaining some steam this spring, including recent employment and housing numbers along with more specific data such as total railcar and intermodal traffic volumes up 6% on a year-over-year basis, truck tonnage up 5%, port activity in Long Beach, Calif. (one of America's largest ports), up 5%, and rising hotel revenues. Second-quarter GDP growth is likely to hit 3%, which should place a floor under bond yields. The more important question is whether the economy can maintain that strength over the second half of the year. If it can, bond yields have likely seen their lows for the year.Despite Low Rates, Bond Buying Continues
In addition to slow U.S. growth, there are other reasons why investors are flooding into bonds despite their low yields.
Many institutional investors are rebalancing their portfolios after 2013's heroic equity gains. Many institutions are engaging in long-term liability management at precisely the wrong time by shifting assets into long-term obligations paying extremely low yields. This virtually guarantees long-term underfunding since their liabilities are continuing to rise at high single-digit rates. This may be unwise, but it is happening nonetheless.
And European interest rates have dropped significantly, based on public statements by European Central Bank President Mario Draghi promising action to stimulate still-struggling European economies.
The ECB is expected to lower its benchmark lending rate and to impose negative rates on funds held at the ECB. This has resulted in yields on the bonds of weak peripheral countries such as Spain and Italy trading below 3%, which in turn has placed further downward pressure on global rates.
Third, and perhaps most importantly, the Federal Reserve has engaged in what is called "forward guidance," which is Fed-speak for...
...when the Fed speaks. Federal Reserve Chair Janet Yellen has repeatedly stated that she has no intention of raising interest rates for the foreseeable future. The market appears to take her at her word even though recent inflation and jobs data are starting to undercut the case for keeping the Federal Funds rate at zero for a prolonged period of time.Don't Be in This House of Cards When It Falls
The reality facing the Federal Reserve is that the U.S. economy remains too weak to withstand higher rates. The housing market weakened considerably after interest rates rose by 100 basis points in the summer of 2013.
The federal budget deficit would explode were interest rates to normalize. The entire edifice of leveraged finance would collapse under its own weight if interest rates rose by 200 basis points, dragging into bankruptcy a number of large leveraged buyouts.
For this reason, the Federal Reserve will continue to use its considerable powers to suppress interest rates far below their natural levels for as long as possible. This will have the ironic consequence of helping stock prices continue to levitate despite the fact that low interest rates are a symptom of economic weakness, not economic strength. And while interest rates are likely to rise from their current levels, they are unlikely to spike in the foreseeable future.
The Federal Reserve will see to that.
Instead, rates will remain below normal in order to maintain the post-crisis status quo and give the economy time to grow. The problem is that the economy will never be able to grow fast enough without dramatic fiscal and tax policy initiatives. The current mix of 2% to 3% growth and tepid inflation are offering the veneer of stability that markets like.
Unfortunately, the divergence between stock and bond prices is a warning that this scenario is unsustainable.
Sooner or later, markets are going to demand more growth to service the enormous debts that have been incurred to rescue the global economy from the financial crisis.
If that growth does not materialize - and it is unlikely to do so without dramatic fiscal and tax reforms - equity markets in particular are likely to face a heavy reckoning.Up Next
This divergence, along with inflation that runs 3% to 4% above the "official rate," could wipe out unprepared investors. But these simple moves could save your financial future... Full ReportTags: low rates