The January Stock Rally Could Face a Painful Reversal
After posting their best start to a year in more than three decades, U.S. stocks look poised to extend their relief rally into February. But a closer look at bond prices suggests stock traders could be in for a rude awakening in the near future.
All of Wall Street’s major indexes posted huge gains in January. The Dow Jones Industrial Average rose 7.2% during the month, its best January since 1985. The large-cap S&P 500 advanced 7.9%, its best start to a year since 1987. The Nasdaq Composite Index saw an increase of 9.2% thanks to rebounding technology and communications stocks.
As The Wall Street Journal recently reported, the eye-popping returns for stocks have been accompanied by a similar rise in bonds. This atypical pattern has raised alarm bells about how investors perceive the U.S. economy.
Yields on both short- and long-term government debt declined throughout January, extending a three-month losing streak. Historically, this means that investors are increasingly pessimistic about the health and trajectory of the U.S. economy. Yields fall when bond prices rise.
That yields are falling isn’t the issue. Rather, the concern is that this trend has been unaffected by the month-long rally in stock prices.
The obvious answer is that there is a separation between where stock investors see the world and where bond investors see the world. If their views converge, equity markets could get a replay of December, when the S&P 500 and Nasdaq entered bear-market territory.
Bond investors have seen the yield on the benchmark 10-year Treasury note fall for three consecutive months. That’s the longest streak since mid-2015. On Friday, the 10-year yield settled at 2.690%.
Declining bond yields are usually a reflection of a slowing economy. Although there are no signs of an imminent recession, investors are becoming more concerned about the housing market. The housing recovery has hit a major speed bump over the last 12 months, as affordability challenges continue to thwart demand. The market got much-needed reprieve in November when new home sales jumped 16.9%. However, on balance, housing remains an issue.
Waning consumer confidence and the sudden slowdown in manufacturing are also a concern. The manufacturing sector has seen a sharp acceleration under the Trump administration, as evidenced by the monthly PMI reports courtesy of ISM and Markit. However, ISM’s December manufacturing index witnessed its steepest one-month drop since 2008, as purchasing managers gave a downbeat view of the economy.
The Atlanta Federal Reserve has lowered its estimate of fourth-quarter growth. According to its latest GDP estimate, the economy likely grew 2.5% annually int he fourth quarter. That’s down from a prior estimate of 2.7%. The growth model will be updated again on Wednesday.
Signs of sluggish growth domestically and across the globe have shifted the Federal Reserve’s guidance on monetary policy. The central bank is now expected to hold off on raising interest rates this year. According to Fed Fund futures prices, a rate cut is now considered more likely than a rate hike.
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