Gloomy yield curve

Is the stock market overly enthusiastic about the future of economic growth and corporate profits? Some measures of investor sentiment suggest it is, and PE ratios are above average. But to judge by the bond market, the outlook for economic growth remains dismal. Which one is right?

The bond market currently believes that short-term Treasury yields are unlikely to rise above 3% for the foreseeable future (i.e., the next 5-10 years). Based on the current pricing of Treasuries and TIPS, the bond market further expects consumer price inflation to average about 1.4% per year over the next 5 years (thanks to falling energy prices), 2.1% over the subsequent 5 years, and 1.7% on average over the next 10 years. In addition, the bond market is priced to the expectation that real yields on short- and intermediate-maturity TIPS are unlikely to exceed 1% for the foreseeable future. It all adds up to a very gloomy outlook for the future of U.S. economic growth. The following charts help explain why.

The chart above shows the current Treasury yield curve (blue line), and the market's expectation for the yield curve 2 and 5 years in the future. I haven't shown the 10-yr forward curve because it is substantially similar to the 5-yr forward curve. For those unfamiliar with how the bond market works, forward yield curves are derived mathematically from the current yield curve. I've used Bloomberg's calculations as inputs to the chart.

The first of the above two charts shows the expected future path of the Fed funds rate, using Fed funds futures as the data source. The Fed funds rate used to be the Fed's primary interest rate target, but that's changed now that bank reserves pay an interest rate that is determined by the Fed. When the Fed starts to tighten (according to the futures market, sometime around the middle of 2015), they will simply increase the interest they pay on reserves, and presumably the Fed funds rate will follow rather closely behind. Here we see that the market expects the funds rate to reach about 2.5% within 5 years, which is consistent with the first chart in this post which shows the market expecting 3-mo. Treasury rates to be just above 2.5% within 5 years.

The second of the above charts shows the expected future path of 3-mo. LIBOR, using Libor futures as the source. 3-mo. Libor typically exceeds the Fed's targeted overnight rate by 20-30 bps, in order to compensate for banks' perceived credit risk. As the chart shows, 3-mo. Libor is expected to hit 3% within 5 years, and that's as high as it's going to get. This also is consistent with the 5-yr forward Treasury curve's projections of 3-mo. Treasury rates.

So, the bond market sees the Fed starting to raise short-term rates in about six months, and then raising them gradually until it stops in 5 years just short of 3%.

What does this say about expectations for economic growth? It's not very encouraging at all.

The above chart gives us some historical perspective. 10-yr Treasury yields have only been lower than 3% during the years following the Depression, and briefly in the years following the Great Recession; both periods were times of unusually weak growth and a lack of confidence. Yields were substantially higher in virtually all other periods. During the high-growth Reagan years, for example, when inflation averaged some 3.5% and real growth averaged about 4.5%, 10-yr yields averaged about 9.5%. During the strong-growth period of the Clinton years, when inflation averaged 2.5% and real growth averaged 4%, 10-yr yields averaged more than 6%. In other words, today's 2.3% 10-yr yield almost shouts "slow growth ahead!"

As the chart above suggests, nominal 2-yr yields have tended to approximate the nominal growth (inflation plus real growth) of GDP. Except, of course, for the past 10 years or so, when the Fed kept short-term rates unusually low for an unprecedented length of time. If we were living in "normal" times, today's 4% nominal GDP would give us 2-yr Treasury yields of 3.5-4%. But the bond market doesn't think we'll ever get back to normal again, because forward yield curves say 2-yr Treasury yields will never exceed 3%.

As the chart above suggests, real yields on 5-yr TIPS have tended to move in line with the economy's real growth rate. When real growth was very strong (4-5%) in the late 1990s, real yields were very high (3-4%). Now that growth has slowed considerably (averaging 2.3% for the past 5 years), real yields have traded within a -2 to 0% range. Real yields have moved up a bit over the past year or so as the market has stopped fearing another recession, but real yields on TIPS are still priced to miserable growth expectations. Based on forward curves, real yields on 5-yr TIPS are expected to rise to 0.8% within 5 years. According to this chart, that would be consistent with real economic growth of only 1-1.5% per year.

In short, the bond market is behaving as if growth and inflation are going to be unusually low for the foreseeable future, and that therefore the Fed is not going to increase short-term rates by more than 3% over the next 5 years. The last time the Fed tightened, they increased the Fed funds rate from 1% in mid-2004 to 5.25% over the subsequent two years. The bond market is now looking for only a 3% increase spread out over 4 ½ years. If that isn't a timid projection, I don't know what is. The Fed is likely to pursue such a path only if the economy proves to be very weak and inflation stays unusually low.

If there's one thing positive to say about the yield curve, it's that it shows no indication of an impending recession for the foreseeable future. All recessions in the past 50 years have been preceded by flat or inverted yield curves, and we're miles away from that at present.

I would argue that the expectations of the stock market are necessarily entwined with the expectations of the bond market. They're both essential parts of one gigantic capital market. The stock market can't be "overpriced" if the bond market is convinced we're stuck in a slow-growth, low-inflation world for as far as the eye can see.

Consider: the bond market is saying that the proper discount rate for expected future earnings is 3% or so. That alone would justify PE ratios substantially higher than the long-term average, since discount rates have rarely been so low in modern times. Plus, are stocks expensive if their earnings yield, currently 5.5%, is substantially higher than anything we're likely to see from the Treasury market, and higher than BAA corporate bond yields? A relatively high earnings yield only makes sense if the equity market is priced to the assumption that corporate profits are going to decline in coming years.

To answer the question posed above, both the bond and equity markets are "right," because they are both priced to similar assumptions. That is, both markets believe we're going to be stuck in a very slow-growth world for many years to come, and inflation is going to be relatively low and stable (1.5-2%) once we get past the current period of falling oil prices. By the way, I think the pricing that is implicit in bond and stock prices trumps whatever investor sentiment surveys reveal. After all, "the market" incorporates the bets of everyone, not just those selected for a particular survey.

I've held the view that the market has been consistently underestimating future growth for the past 5-6 years, and I suspect it still is. As for inflation, I've been wrong to expect it to rise, but I continue to believe that there is more risk of higher inflation than there is of lower inflation. In a similar vein, I continue to think interest rates are likely to be higher than the bond market's current projections, even though I've been wrong on rates for years.