Stocks and Bonds Are Sending the Correct Signals
(Bloomberg View) -- What does a post-crash, post-austerity, post-globalization global economy look like? As close to perfect as possible, based on how investors are pricing financial volatility, credit spreads and equity risk premiums. Or, a time for caution based on the flattening of the yield curve, when the spread between two- and 10-year U.S. Treasury note yields is the lowest in a decade.
It is possible that both signals are right. An explanation would go something like this: A narrowing yield curve normally indicates investors are less confident about the economy’s future pace of growth, and that real gross domestic product and inflation won't be much stronger. Although the economy is not about to fall into recession, it is close to the peak for this growth cycle.
The signals sent by risk assets aren't inconsistent. The Cboe Volatility Index, or VIX, reached an all-time low of 8.56 on Nov. 24, even as both investment-grade credit spreads and the difference in yields between investment-grade and high-yield bonds compressed to the least since before the global financial crisis. This is a true signal that the search-for-yield “risk on” party is far from over. But it would be a stretch to expect the gains of 2017 to be repeated in 2018 given the starting point of current levels, even if companies continued to enjoy double-digit profit margins on top of nominal GDP growth. In other words, we are close to the peak of the investment cycle.
Figuring out where markets go from here presents a two-sided question for investors. First, are current risk valuations sustainable? And second, is bond yield volatility likely to remain low? The first concerns how markets have valued risk over this cycle. The second is about how the Fed and other major central banks manage the transition to a more normal policy environment ahead.
Before answering those questions, it is worth understanding how we got to this point. The global financial crisis was not just a credit event, but the beginning of an unprecedented era in monetary policy. Central banks, seeking to spark the global economy out of a credit depression, employed everything from marginal negative interest rates to asset purchases via quantitative easing to currency devaluations to arrest the recessionary, deflationary forces of forced bank deleveraging and defaults. The result has been large-scale asset appreciation accompanied by depressed long-term bond yields and volatility.
Indeed, U.S. 10-year Treasury yields at about 2.40 percent are practically unchanged from a year ago. That would make little sense in a growing economy that has seen four interest-rate increases by the Federal Reserve in the same period if it weren’t for negative term premiums in the bond market. In contrast, two-year yields are the highest in almost a decade, following the Fed’s rate hikes. These moves, which have flattened the yield curve, tell us little that we don’t already know about the economy: it's operating close to full capacity at a time when international financial conditions remain extremely accommodative.
With the major central banks holding almost $20 trillion of assets combined, it's unlikely that excess liquidity will disappear in the short run, even as the Fed scales down its balance sheet and the European Central Bank tapers its asset purchases in 2018. The legacy of financial crisis, in the form of high debt levels and a secular decline in productivity growth, means that the Fed and other major central banks are prevented from raising rates to levels commensurate to nominal GDP growth without running the risk of triggering a recession and another solvency crisis.
Central banks are looking to extend the business cycle by removing policy accommodation in a gradual and transparent manner, minimizing financial volatility. If funding costs remain below returns on investment in the real economy, then equity and credit valuations would be structurally higher than in the past.
Does this mean that this liquidity risk rally will last indefinitely? Here, history is a good guide. Back in 2005, then-Fed Chairman Alan Greenspan described a “conundrum” in U.S. bond markets, where long-term rates were trending lower even as the Fed was increasing rates. The S&P 500 went on to deliver a 16 percent return in 2006 in benign economic conditions. Then, it became clear that the liquidity-led rally had over-extended itself, culminating with the beginning of the financial crisis.
At today’s depressed yield levels, the next crisis will be all about valuations. And with volatility near historic record lows, the starting point for valuations is higher than in the past. At the least, the risk of market corrections balance the potential for continued gains. It is possible that both equity markets and the yield curve are right: We are near the peak of the cycle
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Lena Komileva is managing partner and chief economist at G+ Economics, an international market research and economic intelligence consultancy based in London.
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