It’s all a bit confusing.
For financial market observers like myself this is an unusual time. Bond market prices reflect a likely slowdown in economic growth, but stock prices say otherwise. We’re getting mixed signals on the economic outlook.
Consider first the bond market. The U.S. yield curve — a graph of interest rates on US Treasury bonds by their length to maturity — has flattened. Over the past couple of years, short-term rates have risen in response to a change in monetary policy from the Federal Reserve, but long-term rates have stayed relatively the same.
The gap between two-year and 10-year Treasury yields is just 15 basis points, or 0.15 percent. Over the past 40 years this difference has averaged 95 basis points, or nearly 1 percent.
When the yield curve is flat, or the gap small, investors must believe that rates will be lower in the future. This occurs because investors are buying more long-term securities relative to short, keeping long-term rates down (the yield on a bond and its price are inversely related). In contrast, when the yield curve slopes upward, or the gap is wide, investors are buying more short-term bonds now because they expect future interest rates to be higher.
So the bond market is currently forecasting steady or falling interest rates, which generally occurs when the economy is slowing down and inflationary pressures are declining.
However, current inflation is already at a relatively low level, as measured by the consumer price index. The U.S. Bureau of Labor Statistics reported this month that consumer inflation rose just 1.5 percent over the last 12 months, compared with the 40-year average annual change of 3.7 percent.
Inflation in our area is relatively higher but still below average. The CPI for urban consumers in western cities with a population the size of the Boise Valley rose at an annual rate of only 2.5 percent.
While the bond market is expecting slow growth and low inflation, stock prices tell a different story.
The Dow Jones Industrial Average, at around 26,000, is off its all-time high reached last fall but up strongly this year. The NASDAQ Composite Index also remains off its high but has risen quickly in the first two months of 2019.
Stocks are more difficult to assess than bonds, where returns are known by the bond’s yield to maturity, but a common stock valuation measure shows relatively high expectations for economic growth. These expectations are most often measured by comparing current corporate profits, or earnings, to the price investors are willing to pay for stocks.
At current prices, the average U.S. stock has a price-to-earnings ratio of 18, or inversely, an earnings yield of 5.5 percent. This yield is more than double what investors can expect to earn on safe U.S. Treasury bonds. Such higher returns should only be true when companies can grow their earnings strongly. Otherwise, investors would be better off holding less risky bonds. Stocks are currently priced to return much more to investors than bonds.
Some stocks of interest to Idaho investors have above-average PE ratios, and thus even higher growth expectations. For example, Idacorp Inc. (parent company of Idaho Power) and Boise-based U.S. Ecology Inc. both have a current PE ratio of 21.
So which market is correct?
I am generally optimistic and tend to look at the stock market for an economic forecast. Stock investors take more risks but in turn have more incentive to price their investments correctly. The bond market is heavily influenced by potentially erroneous Fed policy, and bond investors sometime hold these investments as an alternative to cash, having no real outlook on the economy.
It’s confusing, but the stock market is telling us to expect good economic growth.
Peter Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. firstname.lastname@example.org