Many view the ascent of the Dow Jones Industrial Average above 20,000 as a sign of optimism about President Donald Trump’s economic policies and the long-term economic growth outlook for the United States. The bond market is sending a different signal: It is priced for a relatively slow growth path for the rest of the decade.
The focus on the milestone for the Dow – an index of 30 publicly traded stocks that for over 130 years has resonated on both Main and Wall Street as a gauge of the nation’s well-being – is easy to understand, particularly given the fascination people tend to have with round numbers. There are practical reasons that warrant attention.
Rising equity prices can influence the U.S. economy and its financial markets in two ways:
- Wealth effect: A wide variety of research indicates that household spending benefits from rising stock prices. Studies suggest that for every $1 increase in the value of stocks, households will increase their spending by 3 to 5 cents. With U.S. equities up over 10% since the election and valued at $37 trillion at the end of September, according to Federal Reserve data, consumer spending looks poised to rise.
- Animal spirits: To quote the famed economist John Maynard Keynes, “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits ….” Rising stock prices can therefore influence both consumer and business confidence, affecting behavior and the rate of economic growth.
In the aftermath of the financial crisis, the Federal Reserve has endeavored to build a bridge to a time when it could pass the baton to the nation’s fiscal authority to help solve the nation’s economic growth problem. This has required a leap of faith by investors, and they have taken it, as evidenced by the strength of the stock market.
Now, with the U.S. moving away from central bank dominance toward some degree of fiscal dominance, for the leap of faith to truly pay off, Washington must promote growth in a way that permanently alters the U.S. growth trajectory. To do so, the U.S. must overcome headwinds from demographics and indebtedness and increase its productivity. This is a big undertaking, requiring a focus on the long-term drivers of growth such as education and investment.
Only then will bond yields move more appreciably and sustainably higher. For now, markets are appropriately skeptical, priced for the Fed’s policy rate to end the decade at around just 2%.
Tony Crescenzi is a market strategist and generalist portfolio manager. He is a frequent contributor to the PIMCO blog.