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Is the economic recovery for real? Bonds may offer a clue

JUL. 15, 2020

Citi Economic Surprise Index vs Six-month change in 10-years U.S. Treasury yields, 2003 to July 2020 chart

At the start of this year, the bond market and stock market told two completely different stories. Equity markets, on the heels of a 31% gain in 2019, hit record highs in February. Valuations also rose to near 20-year highs and investor sentiment was extended. The bond market’s view, however, was more consistent with recessionary conditions: low interest rates; a flat yield curve; and a Federal Reserve in easing mode. While it’s absurd to suggest the bond market predicted a global pandemic, fixed income investors historically operate with more caution and skepticism than equity investors.

Since April, the trajectory of economic data has reversed from the shocks of the early pandemic shutdown. One way to view this reversal is the Citi Economic Surprise Index, which measures how close actual economic numbers come in relative to analyst expectations. In April, this index hit a record low of -145, as no analyst expected the extent of the COVID-19 economic damage. The index is currently at a record high of +224, as recent data easily surpassed pessimistic assumptions.

Historically, the bond market has closely tracked this index; interest rates rose when actual data beat expectations, then fell when the data missed. More recently, however, the two lines have dramatically diverged—interest rates are now hovering near historic lows even as economic data suggest improvement. While it’s reasonable to assume the combination of aggressive Fed stimulus and general pessimism is causing the divergence, this indicator bears watching as it could signal the current recovery is a head fake.

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