The bond market is flashing warning signals that bad times may be ahead for the stock market and the economy.
That is probably not what most people want to hear — stock investors especially. In the first half of the year, after all, stocks have performed spectacularly. The Standard & Poor's 500-stock index returned 9 percent through June, churning out gains so regularly that it may seem churlish to note that clouds are appearing on the horizon.
Simply put, while the Federal Reserve has been raising short-term interest rates since December, the bond market hasn't gotten the memo. The longer-term rates that are set through bond market trading have, for the most part, been declining, though there was a brief reversal in the last few days. But the disconnect over the last few months is a sign that bond investors believe economic growth and inflation are still weak and the Fed's actions are premature.
In the past, when disputes between the Fed and the bond market have persisted and grown, they have sometimes predicted big problems ahead — like a plunging stock market and, eventually, a recession.
Though there is widespread concern about the behavior of the fixed-income markets, some analysts aren't as convinced that the forecast is quite so gloomy.
Understanding the situation more deeply requires a little technical knowledge, so bear with me.
The Federal Reserve, along with other central banks, lowered short-term rates to near-zero levels during the financial crisis. With the economy on the mend, and asset prices like stocks and real estate soaring, Fed officials have begun raising short-term rates and say they intend to continue to do so.
What is unusual is that while the short-term rates that are controlled and heavily influenced by the Fed have been rising, the longer-term rates that the bond market sets have generally been dropping. That is why 30-year fixed mortgage rates are still below 4 percent, not all that much higher than they were a year ago.
The benchmark 10-year Treasury note, for example, declined from more than 2.6 percent in March to about 2.1 percent earlier in June. (It rose to 2.3 percent on Friday.) The rate on the 10-year note has been hovering at only about 1 percentage point above the Fed funds rate and 0.6 or 0.7 of a percentage point above the three-year Treasury note.
In bond market jargon, "the yield curve has been flattening" — meaning short- and long-term interest rates have been moving closer to parity. In itself, such a development is unusual. But if the trend continues, with shorter-term rates rising above longer-term rates, the message from the bond market would amount to a flashing red light.
In such a case, bond mavens would say, "The yield curve has inverted," implying a reversal of the natural order of things, because most of the time, investors demand a yield premium for tying their money up for longer periods. An inversion would express deep skepticism about Fed policy and about the health of the economy. In the past, inversions have often predicted economic recessions and sharp declines in the stock market.
In fact, the last yield-curve inversion occurred in 2006 and 2007, according to data maintained by the Federal Reserve Bank of New York. Recession probabilities climbed, a model maintained by the New York Fed showed, and for good reason. The economy plunged into recession in December 2007, and, by some measures, it is still recovering. That's why the yield curve's messages are worth taking seriously.
That said, we don't have an inversion at this point, and we may not go there at all.
"Just because the yield curve is flattening doesn't mean that it will become an inversion," said Jeffrey Kleintop, chief global investment strategist at Charles Schwab. At the moment, he said, the British economy has been battered by "Brexit" and other worries and is quite vulnerable to a downturn. But he believes that the probability of a recession in the United States in the next 12 months is low. "I think we've probably got a year or more of growth ahead here," he said.
Mr. Yardeni remains bullish on United States stocks and is cautiously positive about the economy, saying low bond yields probably reflect persistently low inflation, which could be benign. Factors like demography (the aging of the baby boom generation), technology (the efficiency of smartphones and cloud computing) and globalization have changed the economy and reduced the inflation rate, he said.
Low inflation, along with low global interest rates, are at least partly responsible for the low bond yields in the United States. Those low yields have been a boon to people who own bonds because yield and price move in opposite directions: The benchmark Bloomberg Barclays Aggregate index returned more than 2.4 percent through June, despite predictions early in the year of bad times for bond investors.
The danger signals from the bond market could easily change to another pattern. The Fed may pause in raising short-term rates, though that could unleash irrational exuberance and drive already stretched stock prices higher. On the other hand, the bond market could blink, raising bond yields and relieving the tension. But that would be far more likely if, counter to current expectations, inflation or economic growth began to surge.
For now, the rally in risky assets like stocks continues unabated, while the conflict between the Fed and the bond market continues. Fed officials indicate that they are determined to keep raising short-term rates and to begin reducing the Fed's bond holdings — perhaps preparing the central bank for action whenever the next recession comes.
At a bare minimum, the policy choices ahead are difficult. And for investors, there is ample reason for caution.