Many of the country's most prominent economists are perplexed by the seeming contradictions in the economic data in the wake of the Great Recession. The very nature of this contraction, however, presents its own set of novel events. Moreover, the extraordinary actions of the Federal Reserve have too, set the stage for outcomes that are perhaps contradictory and certainly unpredictable.
We're seeing just such a contradiction in the capital markets, as many have identified. The bond market, with record low yields is suggesting a looming depression or further economic contraction. The equity markets, however, continue to push against record highs, forecasting optimism about the economy and continuing corporate profits. So who is right?
This may not be a contradiction at all, though, as the markets may be trading on forces far more powerful than fundamentals. This is the stage set by Federal Reserve policy. Bond prices rise as yields fall, or stated more accurately for the nature in which this market operates, yields fall as bond prices rises. This seemingly insignificant distinction is being made to highlight the following. There really is no contradiction in stock and bond markets. Both are moving in the same direction - up. Driven by excess liquidity all financial assets are moving higher in price. This is one of the many distortions that are being forced by the Fed. Hence, the predictive properties of these markets can no longer be trusted.
The other glaring contradiction of consumer spending, outpacing personal income growth appears to now be self-correcting. Following three straight months of declines in retail sales, the consumer's ability to outspend income may have reached the limit of their savings and borrowing power. This presents a great challenge for corporate profits and GDP, as large corporations exposed to the consumer like P&G and Intel are already feeling the pinch.
The question on all our minds now, is what happens next. As the Fed (or at least market participants) contemplate a QE3, the limits of intervention may already be upon us. If this is true, and the consumer no longer has the resources to drive corporate gains, then the disequilibrium in the financial markets may soon also self-correct.