Post last Friday's strong US employment data the focus for equity and bond markets has turned on the Fed Chairman Jerome Powell's congressional testimony over the next two days. The optimism the Fed would cut rates by 50bp at the July meeting has been part of the reason equity and bond markets have been rising in the past month. The expectation is now for the Fed to cut by 25bp at the July 31st meeting. Equity markets have taken this news better than bond markets as yields have risen sharply. The two asset classes performance has been highly correlated over the past months; that correlation has broken down in the past few days. This relative move possibly reflects the level of sentiment that had become towards the two asset classes.
The reaction from the bond market has meant that, according to the NY Fed's recession indicator, the probability of an economic recession has increased. If one uses history as a measure, on previous occasions when the probability has reached this level, a recession has been the outcome.
Aside from the employment data, there are other indicators, such as the output gap, the performance of steel and lumber prices that could suggest we are on the cusp of an economic recession. Despite the uncertainty, the US equity markets remain close to all-time highs. Equity indexes continue to reflect the expectation, particularly while inflation remains at or below central bank target, that interest rates can be kept at a place that leaves room for central banks to move if they feel the need. One can also see why equities remain in demand as almost 50% of equities that make up the S&P 500 have a dividend yield above that of the 10-year US treasury. The historical average is below 20%. The investing world continues to face a dilemma it has faced for many a year. Bonds look expensive compared to history but provide a safe haven in the times of economic uncertainty. Equities look riskier as economic uncertainties remain, however central banks continue to pursue measures that support riskier asset classes.