

Market Analysis
Bond investors are typically seen as pessimists, while equity investors are viewed as optimists. Yet, this conventional wisdom doesn’t fully explain the growing divide between the two groups' perspectives on the U.S. economy and potential interest rate cuts.
Interest rates markets are currently forecasting a dramatic easing cycle from the Federal Reserve, consistent with significant market disruptions or a recession. Meanwhile, Wall Street maintains high equity prices, trading on expectations of over 15% earnings growth next year.
Something doesn’t quite add up.
Half Empty?
The bond market is often considered a more reliable indicator of economic and monetary policy trends compared to the stock market. However, it has consistently misjudged the U.S. economy’s resilience and been premature in predicting the start of the Fed’s easing cycle.
Rates futures predict nearly 100 basis points of cuts over the Fed's remaining policy meetings this year, with 150 basis points by March and 200 basis points by September next year. The negative spread between the fed funds rate and the two-year Treasury yield is at historic levels.
Such aggressive easing expectations align with past recessions or market crises, like those in the early 1990s, the dotcom crash, the Global Financial Crisis, and the COVID-19 pandemic, according to Bob Elliott, CEO of Unlimited Funds and a former executive at Bridgewater.
"Current pricing of cuts this quickly is in line with the depths of past recessions or crises, not stocks basically at all-time highs," Elliott notes.
Although U.S. rates futures have calmed since the volatility shock on August 5, they still imply a one-in-four chance of a 50 basis point cut at the September meeting. Historically, the Fed has only begun easing cycles with a half-point cut in January 2001, September 2007, and October 2008, with two of those being emergency actions.
Or Half Full?
On the other hand, the stock market is not reflecting a recession. After recent declines, driven by unwinding crowded trades and a selloff in major tech stocks, equities have staged a strong recovery. The S&P 500 is now close to its July record high.
Shares of Nvidia (NASDAQ: NVDA), a symbol of the AI boom, have surged 43% in just two weeks. The second-quarter earnings season shows S&P 500 profits up 13.4% year-over-year, exceeding early estimates. Nine out of eleven sectors reported increased profits.
The forecast for S&P 500 earnings growth next year is even higher, at 15.2%, with every sector expected to see growth. Market optimism likely hinges on expectations of lower discount rates, but the outlook for consumers and corporate profits remains positive.
Stock Market on Target?
So, what might the bond market be seeing that the stock market isn’t?
This divergence might be a mirage, explained by examining the real, inflation-adjusted federal funds rate and changes in the so-called R-star—the Fed's estimate of the long-term neutral interest rate that neither stimulates nor restrains economic activity.
With inflation cooling, the Fed’s policy target range has remained at 5.25-5.50%, pushing the real fed funds rate to nearly 3%, the highest since 2007. The Fed estimates R-star at 2.8%, suggesting that the policy rate could be cut by 250 basis points and still be considered restrictive. Thus, significant rate cuts might not necessarily signal a recession or crisis.
However, with a modest unemployment rate, healthy economic growth, and narrow credit spreads for investment-grade and junk-rated firms, it’s difficult to argue that policy is excessively tight.
Perhaps traditional rules no longer apply to today’s economy. Despite historical precedents, the equity market might be on more solid ground.
"You look at earnings, and it doesn’t look like we are in a recession," says Callie Cox, chief market strategist at Ritholtz Wealth Management. "I would believe the equity market in this scenario. The equity market has this right—the economy is still in a good position."
Historically, the bond market has been a reliable indicator. But maybe, just maybe, this time is different.
Paraphrasing text from "Reuters" all rights reserved by the original author.