Stock bulls vs. bond bears: Who comes out on top?

With the market rally gaining traction on the hope of peak inflation, the spread in yield between 2-year and 10-year U.S. Treasuries appears to think otherwise. Some recent positive economic news boosted bullish sentiment, primarily the July Consumer Price Index (CPI) reading. The headline inflation number showed CPI was flat in July, mainly due to falling gas prices. That lowered the year-over-year CPI number to 8.5% (from 9.1% in June) and gave investors a much-needed reprieve. Likewise, the Producer Price Index (PPI) in July decreased by 0.5% from the prior month due to a slide in energy prices.

Thanks to the better-than-feared inflation reports, the “peak inflation” and “peak Fed rate hikes” narrative enlivened the market bulls, sending the S&P 500® Index higher last week and roughly 16% from its June low. The current bear market rally needs to break through a significant resistance level of 4222 to support the bull market’s narrative of peak inflation and to improve consumer sentiment acting as a tailwind. Yes, positioning, corporate buybacks, and technical dynamics will likely work as a market tailwind. However, the 2-year/10-year yield spread sends a very different signal about the economy that rising equity prices will not subvert slowing growth.

The closely scrutinized spread between the 2-year and 10-year Treasury yields notched another record for inversion, hitting a level not seen since early 2000. Arguably, the bond market might signal that inflation will likely remain uncomfortably high for the foreseeable future. Unlike the current equity market rally, the bond market seems convinced of a coming recession. According to the market bears, the prospects of a hard landing are increasing as wage growth remains firm and productivity remains weak, ultimately driving consumer prices higher.

The bond market also believes Fed officials are unlikely to view the current CPI and PPI reports as a signal to moderate their current steep tightening path, as the lessons from 1970 taught the Fed the peril of a stop-and-go approach. According to the University of Michigan Survey (preliminary), inflation expectations have increased over the long run (5-10 years) to 3.0%. The astute bear investor will recall that Fed chair Jerome Powell was prompted by inflation expectations rising several months ago to hike by a larger-than-expected 75 basis points in June. This data point might pour cold water on the idea of a Fed pivot, and the recent rally in equities might be short-lived as investors continue to re-assess earnings growth in the coming quarters. The yield curve has a long and generally solid record of signaling an economic slowdown is on the horizon. Ignoring this omen in favor of short-term rallies might place investors squarely into the proverbial “bull trap.”