Markets signal economic expansion maturing

The stock and bond markets have been moving in different directions for the past several months. This divergence could offer a clue we’re entering the late stages of an economic recovery. The correlation between stocks and bonds isn’t a foolproof signal of where we are in the cycle, but it’s possible to make some generalizations.

Typically, at the top of the cycle (when things are going well), stock prices rise due to higher corporate earnings, but bond prices fall as inflation fears surface and the Federal Reserve raises interest rates to prevent excesses. This tightening by the Fed didn’t happen in 2006-2007. As a result, the real estate market continued higher into bubble territory. Absent this mistake by the central bank, what normally happens is that higher interest rates (lower bond prices) eventually cause the economy to slow down. But going into the top of the market, rates are moving higher and so are stock prices.

At the very top of the cycle, stocks begin falling in anticipation of a slowdown. The correlation between stocks and bonds reverses, where bond prices are falling (interest rates are going higher) and stocks are also falling, indicating a recession is around the corner. The stock market is often used as a leading indicator of where the real economy is headed.

After the cycle peaks, falling stocks confirm corporate earnings are declining. As the recession gets worse, however, banking authorities typically begin to lower interest rates to stimulate the economy. Thus, going into the bottom of the cycle, stock prices are declining, but bond prices start going up (interest rates decline). At this point, there’s a negative correlation between stock prices and bond prices — they go in different directions.

Theoretically, at the very bottom of the cycle, rising stock prices forecast an economic recovery a few months down the road. So at the very bottom, stock and bond markets re-sync as both stock prices and bond prices rise. Stock prices forecast recovery, while bond prices rise because central bankers are lowering interest rates to stimulate demand. In 2009, for example, stock prices rallied while central bankers cut interest rates almost to zero.

Since then, however, the cycle has moved on. Now the stock and bond markets are moving in opposite directions. Since August, stocks have been moving up fast while bond prices have plunged (interest rates have increased sharply). The divergence — or “negative correlation” in statistics-speak — hasn’t been this extreme since 1956. I’m not exactly certain what this means, other than it’s a good bet that at some point in the near future, the correlation will begin reversing direction with stock returns and bond returns once again linked.

If interest rates continue to rise, bond prices will fall. If the stock market syncs back up with bonds, then stocks would fall as well. With rates rising, we want the divergence (negative correlation) to continue for a bit longer. We probably want these late-cycle conditions to last as long as possible!

We appear to be in a classic late-cycle expansion. Growth can continue in spite of rising rates because they haven’t yet reached a high enough level to matter. Corporate profits remain strong and corporations are flush with cash.

Certainly, the fact that banks are hoarding capital makes this cycle a bit different. But the general conditions of a late-cycle expansion remain. Inflationary pressures are increasing, even if government statistics don’t show it.

For now, we appear to be in the late stages of expansion. These are typically robust times for business. As long as interest rates don’t go too high too quickly, the good times can continue. While the good times are here, we want to be invested in areas that reap the rewards. Nor do we want to take our eyes off the exits.

This cycle won’t go on forever. And given its “late stage” characteristics, it’s more important than ever to watch diligently for the time when the correlation between stocks and bonds reverses direction once again.