Are equity markets trying to tell us something?

Donald Trump isn't always wrong about everything.  He's certainly correct when he says that the US economy is doing well, though he's equally surely wrong when he tries to claim all the credit for the steady growth and rising employment that continues month after month.  Even the IMF, rarely accused of enthusiasm, is boosting its growth forecasts for 2018, not just for the US but for the entire global economy.

So why are we seeing clear signs that the long-lasting bull market in equities is coming to an end?  Why, right after the Department of Labor released a stronger-than-expected non-farm payrolls report for January, did the Big Board sell off by more than 1 percent this morning? 

A clue to the answer can be found in the quote (within the linked article) from an economist at BMO Capital Markets.  He refers to the "relentless" rise in bond yields, which has taken the 10-year Treasury yield to (I hope you're sitting down at this point).... 2.8 percent! 

Those of us with longer memories than BMO man might see that number a little differently.  US nominal GDP is growing at about a 5 percent rate right now.  GDP growth in real terms slowed to about 2.6 percent in the final quarter of 2017, but is expected to maintain at least that pace through this year.  Inflation has edged up to stand slightly above the Fed's 2 percent comfort zone.  Unemployment is at a rock-bottom 4.1 percent and there are increasing reports of labor shortages in certain sectors.  Take all of those factors together, and there's surely a cast-iron case to be made that the 10-year Treasury yield is at least 250 basis points lower than historical experience would suggest.

Without doubt, an economy recording several years of steady growth, with no end to the expansion in sight, should see rising equity markets.  However, the fact that those markets are selling off as the longevity of the expansion seems more assured can only mean one thing.  A large part of the extraordinary run-up in stock prices has been based not on the US economy's fundamentals, sound as they are,  but on the Fed's provision of almost free money over the course of almost a decade.

It seems certain that the post-Yellen Fed will continue the twin paths of slowly raising rates and gradually tapering QE that we have seen over the past year. That implies that the correction in stock prices has further to go.  However, it seems unlikely that the underlying strength of the US economy will be undermined by a further 75-100 bp rise in the funds target and a similar rise in Treasury yields.  This may turn out to be one of the many instances in which the stock market forecasts an economic downturn that never quite materializes.