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The equity risk premium has fallen from its peak, but this has been largely based on a moderation in perceived tail risk rather than stronger growth. Indeed, real GDP growth has struggled so far in this recovery to sustain even a trend pace of 2-2.5%.
In turn, sub-par growth has kept the FOMC under pressure to continually look for ways to provide additional stimulus. Perceptions among policymakers and investors regarding the sustainability of the recovery will change when real GDP growth finally shifts to an above-trend pace. Three key market indicators will signal a shift in perception. First, gold prices should fall in absolute terms and relative to broad commodity indexes. Gold is a liquidity play and its relative performance is highly correlated with risk aversion.
Second, bank stocks should outperform relative to the broad market and rise in absolute terms. This sector provides a read on financial systemic risk.
Third, and most importantly, rising real bond yields would highlight that the economic recovery is becoming self-reinforcing and can handle a gradual withdrawal of monetary stimulus.
All three indicators are flashing ‘green’ at the moment.
This post was originally published by the BCA Research blog.