As investors prepare for an end to the Federal Reserve’s soothing monetary balm, US equities and bonds speak to very different prognoses for the economy. The stock market bull run sits at odds with sustained falls in yields on benchmark Treasury bonds, setting the stage for what could be a turbulent summer when the Fed pulls the plug on its second phase of quantitative easing, “QE2”. Propelled by robust first-quarter earnings results, the S&P 500 index this week touched 1,370, its highest level since June 2008, rising to more than double its nadir of March 2009.
At the same time, 10-year Treasury yields, which move inversely to bond prices, have fallen to 3.21 per cent. They traded above 3.6 per cent less than a month ago. Set aside the brief bout of haven buying in the wake of the Japanese earthquake and tsunami in March and the Treasury yield sits at its lowest level since December. Indeed, after the US economy’s weak first quarter, which equity bulls have played down in expectation of a rebound in coming months, the bond market is gaining momentum. Bond bulls believe the recovery remains fragile as higher food and petrol prices bite into people’s wallets.
There will be no shortage of tests of market sentiment between now and June, when QE2 is due to end. Friday’s release of the April employment report will be one such moment for equities and bonds. The jobs indicator can be expected to set the trading tone for the rest of the month and analysts are anticipating a modest slowdown in hiring. But it is the end of quantitative easing itself that looms as the biggest test. Once the crutch of the Fed’s multibillion-dollar bond buying programme is removed, the economy will have to perform much more on its own. There has been a close correlation between the Fed’s action – and expectations it would act – and the latest leg of the S&P rally. Since official talk of QE2 started last August, with Ben Bernanke’s speech at Jackson Hole, the S&P has gained nearly 30 per cent. The Russell 2000 index of small companies has hit a record high and volatility in equities has fallen. The end of QE2 could well upset this “risk-on” trade. Indeed, there are already signs that that could be happening. Equities have dipped this week, down 1.4 per cent, following weaker than expected US output figures, as risky positions have been scaled back.
“With the flow of monetary policy stimulus ending in June, our uneven economic recovery needs to show it can stand on its own two feet,” says William O’Donnell, strategist at RBS Securities. “I’m concerned if it cannot.” Hence, too, the recent drop in bond yields and an easing in inflationary expectations. “We think the next few weeks are pivotal for the rates market,” says Jim Caron, Morgan Stanley’s global head of interest rate strategy. “If the data aren’t strong enough, then it ups the ante for a downgrade in growth expectations”.
Others are resolutely bearish on bonds. In his latest investment outlook, Bill Gross at Pimco, one of the world’s biggest bond fund managers, said that even if 10-year Treasuries stayed near 3.3 per cent and Fed funds close to zero per cent, “savers and financial intermediaries are being shortchanged by both of these yields and everything in between”. Pimco recently cut its holdings of US debt, including Treasuries, to zero, in the belief that the Fed’s withdrawal from the market as a buyer would send yields up. Complicating the picture for investors is the fact that the unemployment rate, at 8.8 per cent, looks high relative to the outlook for company profits. First-quarter earnings for the S&P 500 are expected to be about $23 a share. Compare that, notes Nicholas Colas at ConvergEx Group, with the first quarter of 2007, shortly before the crisis and the last time earnings were above $22 a share. At the time unemployment was about 4.5 per cent.
On the face it, things look bearish for equities. But the manufacturing sector has been boosted by a weak dollar and a recovering global economy. Subscribe to the view that the S&P is more of a global index and it may be that a big rise in US jobs growth is not required to justify stocks trading at cyclical highs. Yet US stocks’ dependence on global growth prospects for further gains is risky. “The fact that China is aggressively tightening monetary policy in an attempt to slow its economy,” argues Steven Ricchiuto, chief economist at Mizuho Securities, “while the European Central Bank is also tightening to rein in inflation, even as the periphery is facing forced austerity, suggests that global growth is less likely to provide significant upside momentum.” The consensus year-end target for 10-year yields is 3.91 per cent and for the S&P to reach 1,404, according to Bloomberg. If this is accurate, stocks will rise further while Treasuries are overvalued.
“A summer that brings with it an end to QE, benign interest rates, a stable dollar, and oil prices not setting new records could set the stage for a strong year-end rally,” says David Bianco at Bank of America Merrill Lynch.