U.S. equities responded to the Trump presidency with euphoria.
The Dow Jones Industrial Average rose 25% in 2017, becoming one of the best-performing global asset classes. It was a different story with U.S. Treasuries: The yield on 10-year notes fell slightly from 2.44% at the end of 2016 to close 2017 at 2.41 percent. And the spread in yield between two-year and 10-year notes, often a signal of slowing growth or forthcoming recession, plunged from 125 basis points to 51.8 basis points at year-end 2017.
As they receive different messages from equities and Treasuries, investors should pay particular heed to the bond market in making asset-allocation decisions for 2018. Treasuries have been a better predictor of the two recessions in the 21st century — the first lasted from March to November 2001, and the second from December 2007 to June 2009.
In the case of the latter, yields plunged during the months before the recession whereas equities remained strong well into the first half of 2008 when the economy was already in a downturn.
There is good reason to believe Treasuries are sending a warning now.
(Related: Corporate Bonds Sour on the Republican Tax Plan)
The bond market’s sense of caution in 2017 was not assuaged by the successful passage of the tax bill. While the yield on 10-year notes rose to almost 2.50% on Dec. 20 when it became clear the measure would pass and get President Donald Trump’s signature, it fell subsequently, closing the month little changed.
The surge in equities stemmed from corporate earnings that exceeded consensus estimates in recent quarters and, lately, the reduction in the corporate tax rate to 21% from 35 percent. Nonetheless, the decline in bond yields signals that the surge in equities may not be accompanied by faster economic growth or a significant pickup in inflation.