How to interpret mixed messages from bonds and equities

published 6 October 2006

"When asset classes diverge, investors should take note," says The Economist's Buttonwood column. While the Dow Jones Industrial Average has risen steadily since July and is now back at its all-time high, over the same period the yield on the ten-year Treasury bond has slumped from 5.25% to 4.65%. In other words, they are taking different views on the economic outlook: bonds are already pricing in a slowdown followed by rate cuts, while equities are betting that the economy will remain strong (although not so strong that the Fed will hike rates).

With the markets apparently sitting in opposite corners, it's easy to suppose that "one will emerge with a bloody nose", says Thorold Barker in the FT. But it can be credibly argued that both stocks and bonds are factoring in a type of "soft landing" for the economy. If US growth slows, rates will be cut. The result of this will be lower bond yields, which will make stocks look more attractive in comparison. So perhaps both equities and bonds are pricing in this scenario already.

Quite possibly, says Tom Stevenson in The Daily Telegraph. Stocks have tended to rise in the six months following a US interest-rate peak on just this reasoning. But bulls are forgetting that in previous cycles, this optimism over rate cuts has always been replaced by gloom after a few months once the earnings downturn kicks in. It's possible that things will be different this time, but the odds are against it. As Philip Isherwood of Dresdner Kleinwort says, "Generally, investors have lost, not made, money, betting that the cycle has been abolished."

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