Markets swap inflation fear for growth fear

Ten-year Treasury yields have fallen back to between 4.3 and 4.4 per cent over the past fortnight, as markets stopped worrying mainly about inflation and started worrying about growth. High-frequency manufacturing data, retail foot traffic and corporate order books have all softened while businesses wait to see what trade policy brings.

A fortnight of bad news

The turn came quickly. Only two weeks ago a hot January inflation report pushed yields up and bets on rate cuts out. Since then retail sales for January have shown their sharpest monthly fall in nearly two years, an early survey of service businesses slipped below the 50 mark that separates expansion from contraction, and Walmart, the country's largest retailer, gave a cautious outlook for the year that sent its shares down sharply. The S&P 500 set a record high on February 19th and has fallen since.

Washington has added to the gloom. The new administration's cost-cutting drive has begun dismissing probationary federal employees and offering others payment to resign, and contractors in the capital region are bracing for cancelled work. Federal employment is small relative to the economy, but the headlines reach households everywhere, and consumer surveys show confidence slipping as tariffs and job cuts dominate the news. The ten-year yield, which touched nearly 4.8 per cent in mid-January, has now given back most of that rise.

Real yields do the falling

Nearly all of the fall in yields has come from lower real interest rates. Inflation expectations have barely moved. Five-year forward breakevens are still high, reflecting worries that tariffs will feed through to prices, but real yields have dropped as big investors price in a greater chance of recession. Fund managers are cutting their exposure to cyclical corporate credit and buying longer-dated government bonds as a hedge.

The split matters because the two components tell different stories. A nominal yield is roughly the sum of the real yield investors demand and the inflation they expect. When breakevens fall, markets are betting on calmer prices; when real yields fall while breakevens hold, they are betting on weaker growth with inflation still sticky, the combination that leaves the Fed least room to help.

Households feel the move through mortgages. Thirty-year mortgage rates are priced off the ten-year Treasury plus a spread for prepayment and credit risk, so the recent fall trims payments on new loans. It will not do much for the housing market, where many owners are locked into loans taken out at far lower rates before 2022 and have little reason to sell.

The Treasury wants lower yields

Supply has helped the rally along. At its quarterly refunding in early February the Treasury said it expected to keep auction sizes for notes and bonds unchanged for at least the next several quarters, easing fears of a flood of long-dated debt. Scott Bessent, the new Treasury secretary, has also said that he and the president care more about the ten-year yield than about the Fed's policy rate. Bond buyers take that as a hint that the Treasury will lean towards shorter-dated bills if long yields rise, which trims the premium they demand for holding duration.

Lower rates will not save earnings

Shifts from inflation risk to growth risk have usually been hard on equity valuations. Falling rates normally support price-earnings multiples, but they rarely make up for steep cuts to forecast profits. The starting point makes shares more vulnerable: the S&P 500 trades at more than 20 times forecast earnings, a valuation that assumes steady profit growth rather than a slowdown.

The 2001 downturn is the uncomfortable precedent. The Fed cut rates aggressively from January of that year, and yields fell, but the stockmarket kept sliding because profits fell faster than discount rates. Investors who bought equities on the logic that cheaper money must lift prices learned that the numerator of a valuation can move faster than the denominator.

The damage is unlikely to be spread evenly. Smaller companies carry more floating-rate bank debt and depend more on domestic demand, so a growth scare hurts them even as long yields fall, since the short-term rates they pay are set by a Fed that is not cutting. The largest technology firms have been priced for uninterrupted growth, and have the furthest to fall if forecasts are cut. Utilities and consumer staples, dull for two years, tend to hold up best when real yields drop for bad reasons.

Where the argument could fail

The counter-example is 2019. Then too, trade tensions pushed bond yields down and the yield curve inverted, yet the Fed cut three times as insurance and shares finished the year sharply higher, because earnings held up and cheaper money did its work. If the current slowdown proves to be a pause while companies wait for clarity on tariffs, rather than a real contraction, 2019 is the better guide. The difference now is that inflation is further from target, so the Fed cannot cut as freely.

Some of the weakness may also be weather and timing. January was unusually cold across much of the country, which depresses shopping and construction, and the rush by businesses to import ahead of tariffs will distort trade and inventory figures for months. Data that bounce back in February would undercut the growth scare as quickly as it arrived.

What to watch

The next fortnight is crowded. The PCE inflation figures arrive at the end of February, the ISM manufacturing survey follows early in March, and the February jobs report comes a few days later. The 30-day pause on tariffs against Canada and Mexico also ends on March 4th, and the decision taken then will do more to set the growth outlook than any single data release.

Winners and losers are already sorting themselves out. Holders of long-dated Treasuries and would-be mortgage borrowers gain from lower yields, while holders of cyclical shares and lower-rated corporate debt carry the risk. When yields fall because the economy is slowing, bondholders get their protection and shareholders do not, so equity multiples are likely to shrink over the coming months as analysts mark down their earnings forecasts, with small companies and the most richly valued technology names hit hardest by the spring.