Stocks rally on US-China trade deal but bond investors fear recession

Trade talks between the U.S. and China appear to be making some progress and are scheduled to continue in the coming week. That has helped lift stocks, with the S&P 500 up 2.5 percent and the Dow gaining 3 percent in the past week.

The Federal Reserve’s about-face on policy in January has also helped lift stocks and keep bond yields low. After its Jan. 30 meeting, the central bank indicated it is not in a hurry to raise interest rates, and that it could slow down the process to reduce its balance sheet.

For their part, stock investors love low interest rates and an easy Fed. Lower rates also means bond yields do not need to move higher, particularly in an economy that is growing slower with no inflation pressures.

Important for investors is that when these two markets trade in the same direction, there ultimately is a breakout and one dictates direction.

“I think there’s a couple of things in the bond market that don’t connect to reality the way the equity market sees it,” said Hogan.

In his view, the stock market is moving higher based on three assumptions: An end to the U.S.-China trade fight, an accomodative Fed, and continued economic stability in both the U.S. and China.

Conversely, “I don’t think the bond market is behind that narrative,” Hogan added. “The bond market is looking at the economic data stream and reflecting on the negatives.”

Vinay Pande, head of trading strategies at UBS Global Wealth Management, said that the bond market is not trading as if it were reflecting the same growth expectations of the stock market. “Most economists think the economy is slowing, but we don’t know how much it’s slowing. That’s a bit of an issue for the Fed, and that’s why they’re going to be on hold.”

He explained that currently, bonds look as if they see growth a full percentage point below what economists have forecast. The median fourth quarter GDP growth forecast is 2.4 percent, while first quarter is 2 percent, according to CNBC/Moody’s Analytics Rapid Update.

“Is the bond market expressing the longer term consensus? No, it’s not,” said Pande. “The bond market is really trading like it’s a reinsurance market,” where reinsurers will raise prices with each successive event: If there were hurricanes five years in a row, they would still charge as though another hurricane was expected in the sixth year.

That is how the bond market is now responding to weak data — as if it is forecasting an economic storm, or even recession that may not come.

“There’s a muscle memory to this,” Pande added.