Decoding mixed signals
Financial markets are acting like a friend who says one thing but does another. Investors are sending conflicting messages about the economy, interest rates, and what’s coming next.
The mixed signals
Investors are betting that the Federal Reserve will cut interest rates by up to two per cent over this easing cycle. Trump of course, always the glutton, wants even more. That’s a big deal – rate cuts of this size usually happen when the economy is in trouble or heading into a recession. Lower rates make borrowing cheaper, encouraging spending and investment to boost a slowing economy.
Figure 1. One year U.S. Treasury rates with forecast, (%) average of month
Source: Financial Forecast Centre
But equity investors are having none of that. Despite the recession-like expectations of interest rate investors and forecasters, the equity market is signalling everything’s fine. Global stock markets are hitting all-time highs.
Elsewhere, credit spreads – the extra return investors demand for riskier bonds – are extremely narrow. This suggests investors are confident and unworried about economic risks, which is the opposite of what you’d expect if a recession were looming.
Meanwhile, instruments such as inflation swaps – rates have risen since April – indicate investors anticipate inflation to rise, if only marginally. This is puzzling because big rate cuts usually happen when inflation and expectations are low or falling, not rising. Central banks won’t cut if inflation is a threat. Higher inflation will likely prompt the Federal Reserve to maintain higher interest rates to slow the economy.
The soaring stock market, tight credit spreads, and low real yields (bond returns after accounting for inflation) suggest money is flowing freely. When money is “easy,” borrowing is cheap, and investors are happy to take risks. This doesn’t scream “recession” but rather a strong, confident economy.
Normally, these signals line up. If the economy is heading for a recession, you’d see at least a few of the following:
- Expectations of rate cuts to stimulate growth.
- Falling stock prices as companies struggle.
- Wider credit spreads as investors get nervous about risk.
- Disinflation due to weak demand.
Right now, though, the signals are all over the place. Markets expect sizeable U.S. rate cuts, which is normally a recession signal. Stocks are at record highs, credit spreads are tight, and real yields are low, signalling a strong economy. Inflation is expected to rise mildly, which conflicts with the idea of large rate cuts.
This mismatch is akin to market saying, “The economy’s about to tank!” while simultaneously shouting, “Everything’s awesome!”.
Perhaps liquidity is too ‘easy’. When the supply of money is looser, liquidity is high and borrowing can be too cheap for the conditions. Cheap borrowing encourages businesses and consumers to spend and invest. This drives up stock prices and keeps credit spreads narrow because investors feel safe taking risks. It also drives up inflation. But then inflation might be a risk. If inflation does rise (the effect of Trump’s tariffs are yet to be felt), the Federal Reserve might need to keep rates higher to prevent the economy from overheating.
Could interest rates actually be too low? The market’s confidence and rising inflation expectations suggest that rates might not be high enough to keep things in check. And if money is too easy, it could fuel excessive risk-taking (like stock market bubbles) or drive inflation even higher.
Optimism is clearly winning. The strength in stocks and tight credit spreads suggests investors are betting on a strong economy. Either they’re right in thinking the Federal Reserve will cut rates just enough to keep growth going without triggering inflation, or they’re ignoring recession fears altogether. Alternatively, they’re simply fuelling another bubble.
What do I think? I think the answer to the conflicting signals is that markets aren’t always rational. And you have to be on your toes when they become irrational.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
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