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Bond market’s recession warning is at odds with the stock market trading near all-time highs

  • Bonds and stocks signal very different things about the economy, with yields near the lows of the year and stocks near record highs.
  • Treasury strategists say the bond market is signaling the possibility of a recession next year, though several say they are not expecting one.
  • The uncertainty surrounding the policy path in Washington is confusing markets and the outlook for the economy.
  • The bond market is expecting fewer rate hikes, on the view that the economy is growing too slowly and inflation is so low.

Stocks are near record highs, driven by surging tech shares, a sharp contrast with the bond market, where interest rates have been sinking on worries the economy just isn't getting enough juice for growth to pick up.

The S&P 500 also is just a short hop to record territory, and it too tells a very different story from the Treasury market, where the belief is that the Federal Reserve may have to stop raising interest rates after its next hike in mid-June because of weak inflation or growth or both. As of Wednesday, traders were pricing in just 1.4 rate hikes this year, instead of the two forecast by the Fed.

The ups and downs in expectations for fiscal stimulus from Washington have been a factor in the diverging market behavior. "I think it's more like what the growth outlook looks like beyond this year. The market is showing a lot of skepticism about the belief that anything will get done on the fiscal policy side," said Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch.

The bond market has also benefited from low yields in other parts of the globe, which have sent investors into U.S. Treasurys with relatively higher U.S. yields. Yields move opposite to prices.

"Everybody looks at stocks and says: When is the equity market going to have a Trump unwind?" said Michael Schumacher, head of rates strategy at Wells Fargo. Schumacher said the bond market has been factoring out the Trump reflation trade, which sent rates higher right after the election on optimism that tax reform and other Trump policies would lift the economy.

"The market got a little hyped up initially. My sense is it's gone too far the other way," Schumacher said.

Stock analysts say the equity market could see a pullback at some point, but few expect a sharp selloff this summer. Certainly, the stock market does not appear to fear a recession.

"At some point, the bond market is going to be right because you have narrow leadership. At some point, those five or six stocks are going to run out of steam," said Art Hogan, chief market strategist at Wunderlich Securities. Amazon.com, Netflix, and Alphabet, among others, have been powering ahead, helping to pull the stock indexes along with them. "It's hard to pass the leadership from tech to the broader market until we get some answers on health care, and then it's going to be tax reform."

Hogan sees a very shallow sell-off of less than five percent.

Analysts have said the 'Trump trades' related to tax reform and infrastructure have been priced out of specific stocks and sectors, but it's harder to determine how much the broader idea of a reflation trade is still boosting the overall market. The markets began factoring out a big pop from Trump policy in March when the first version of the health-care bill failed to reach a vote on Capitol Hill.

As investigations heated up around the Trump campaign and Russia in recent weeks, optimism for any of Trump's growth policies seeing adoption this year faded even more.

The 10-year Treasury yield Wednesday slid to 2.19 percent, near the low end of a tight range it has traded in since the start of the year. The yield was at a low of 1.85 percent just before Trump won the election. The 10-year yield has gotten ever closer to the 2-year note yield, at 1.27 percent Wednesday. The convergence of the two — or flattening of the yield curve — is also a negative warning, and can be viewed as predicting concern about a weaker economy or that the Fed is raising rates too quickly.

The 2-year yield directly reflects expectations for Fed rate-hiking activity.

"If you're constructive on bonds, at least in the near term, that likely implies a pretty high chance of a recession starting in the middle of next year, and we're not of that view. But that's really what the market is telling you," said Cabana. The market is signaling a period of subdued growth with risks skewed to the downside, he said.

"I've not gotten that sense that the bond market, the individuals, have a recession starting next year as a main point in their central scenario, but again that's what the levels would tell you, and in order for bond yields to go much lower from here, you've got to think the Fed is going to stop hiking," said Cabana, adding the market expects to see a very slow pace of rate hikes going forward. "You're either in a recession or a prolonged period of slow increases in the fed funds target rate. … That's not clearly what the Fed has indicated, and I think a lot of this has to do with different perception of fiscal policy and the underlying outlook for the U.S."

Cabana said he expects the Fed to raise rates in June and September before pausing to begin unwinding its balance sheet at the end of the year.

Fed policy is also affecting both markets differently, according to Peter Boockvar, chief market analyst at Lindsey Group.

"It's the belief the Fed is going to raise rates, and it's a clear difference of opinion," said Boockvar. He said the bond market is questioning whether the economy can handle rate hikes while the stock market is not. "The bond market knows more often than not the Fed tightening cycle leads to recession. That's what history shows. I'm not saying it's going there but people in the bond market know that's where it could lead."

Boockvar noted that there are some telltale signs that the economy is cooling. For instance, car sales have peaked, commercial real estate is topping out, and lending is down, he said.

The disparity between the two markets can also be explained by the fact that low bond yields have driven investors to equities and other assets that yield more.

"Nasdaq going higher is led by a handful of stocks that are growing agnostic of the economy. The bond market looks more like the Russell 2000 and the Dow Transports than it looks like the S&P. If you look at the Transports they're sending the same message as the bond market: 'We're concerned about a slowdown,'" said Hogan.

The Russell 2000 is up just under 1 percent year-to-date, and the Dow Transports are up 1.3 percent. The Nasdaq is up 15.1 percent so far this year, and the S&P 500 is up 7.7 percent.

"You've got a confusing message," said Hogan. He said the 10-year yield going lower often also means the market is reacting to geopolitical concerns, like the North Korean missile program, Brexit or the Italian election.

Schumacher said the markets will be focused on a couple of events in the near future, and that could help resolve some market divergence. "You have the employment report (Friday), the U.K. election on the 8th, and the Fed coming upon the 14th. Those are three things to focus on in the near term," he said.

"I think the bond market always thinks the stock market got it wrong, and vice versa," Schumacher said. "The bond market people are a little more in the weeds of the budget than the stock market."

WATCH: Economic data, the Fed, bond yields driving the market