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Are stock and bond traders really reading Fed differently?

MARKETWATCH 3:34 PM ET 09/18/14


NEW YORK (MarketWatch) -- Bond traders look at Janet Yellen and see a hawk, ready to raise rates next year at a faster pace than previously imagined, while stock investors supposedly see a cooing dove, more worried about a weak job recovery.

In reality, the diverging market reactions are partly due to a question of timing.

"From an equity perspective, the Fed is reacting to better economic data, which in theory should be better for stocks," said Anthony Valeri, senior vice president of fixed-income research at LPL Financial. "Yes, the stock market gets nervous when the Fed hikes rates or gets close to hiking rates, but it's still a long ways away," and the language in the statement was balanced enough to reassure equity investors.

It's a different story for bonds, which are directly affected by Fed rate hikes, particularly at the short end of the curve, he noted. Moreover, bond traders came into the Fed meeting already pricing in far less aggressive rate hikes than the Federal Open Market Committee had projected in its forecasts, known as the dot plot.

In fact, even after the bond selloff, Treasurys are still well behind the Fed, which expects a Fed funds rate around 60 basis points higher than the 0.75% level predicted by Fed funds futures, he said.

Bond market participants appeared to take the Federal Reserve's Wednesday statement, and Fed Chairwoman Janet Yellen's subsequent news conference, as a warning that rates may rise a little faster than had been anticipated when they come. Bonds extended their drop Thursday, pushing the yield on the 10-year Treasury note (10_YEAR) to its highest level since early July.

Stocks, meanwhile, rallied, with strategists offering the explanation that investors were comforted by the Federal Open Market Committee's decision to maintain its pledge to keep rates low for a "considerable time," while also emphasizing a "significant underutilization of labor resources."

Stocks resumed their march to the upside in Thursday's session, propelling the Dow (DJI) and the S&P 500 (SPX) into record territory. See: Stock market live blog.

Bank of America Merrill Lynch credit strategist Hans Mikkelsen said the divergence between bonds and "risk assets," including equities, reflects the ability of the Fed, and Yellen in particular, to "masterfully" guide interest rates higher while simultaneously lowering rate-related uncertainty.

"Rising interest rates reflecting an improving economy is great, as long as the process is gradual," Mikkelsen said, in a note.

Party like it's 2004 ...

If the Fed can continue along these lines, the institution's attempt to normalize monetary policy could look a lot like 2004, he said, a year in which stocks and other risk assets rallied alongside rising bond yields.

The rub, however, is that the Fed's path remains dependent on economic data. So the tightening cycle will remain benign for stocks and other risk assets only "if the economy proceeds like 2004, i.e., a weak, jobless recovery," Mikkelsen said.

... or 1994?

"If the economy is strong, and resumes the path of strong jobs creation, the situation could be much more disorderly," he said, a situation that could be much more reminiscent of 1994, when a rapid rise in rates sank stocks.

European wild card

Nick Ventura, chief executive at Ewing, N.J.-based Ventura Wealth Management, also says Yellen is doing a good job of guiding the market, but he doesn't see a strong corollary between the current market environment and 2004. Ventura doesn't expect a significant rise in bond yields and he sees the Yellen-led Fed as much more transparent than the Greenspan-led institution of 2004.

"If you look at the '04 stock market, it seemed to have a stutter step to it, whereas Yellen might be able to tiptoe out, particularly if she has some foreign demand for Treasurys... It might be similar to '04, but it might be better," he said.

One wild card is Europe, he said, where continued deflation fears could prompt institutional investors to continue buying Treasurys in a quest for yield, artificially holding down yields.

-William Watts; 415-439-6400; [e-mail]

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