The Stock Market may not be Fighting the Fed, but are Bonds?

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

December 14, 2010

Key points

• The stock market may not be fighting the Fed, but are bonds?
• Treasury yields and stocks can rise simultaneously, but dollar strength could bite.
• Investors are being driven to reallocate away from bonds and toward stocks.

To no one's surprise, the Federal Reserve announced no change to its interest-rate policy, keeping the fed funds target rate in a range from zero to 0.25%. There was also no meaningful change to the Federal Open Market Committee's (FOMC) accompanying statement.

For those who doubted the Fed's resolve to retain the $600 billion purchase plan of additional Treasuries (aka a second round of quantitative easing, or QE2 for short) through June 2011, the Fed noted again that the purchases will "promote a stronger pace of economic recovery" and keep prices stable "over time."

But in an interesting twist, the statement suggests the Fed did indeed discuss whether QE2 should stay on target: "… the Committee decided today to continue expanding its holdings of securities as announced in November." This is only six weeks after it was launched!

We continue to believe there may be economic impetus for the Fed to pare back its purchases sometime before the program's expiration, and clearly the FOMC is already discussing that option.

The market first learned about the Fed's intentions to launch another round of Treasury purchases in late August in a speech Fed Chairman Ben Bernanke gave in Jackson Hole, Wyoming. The S&P 500® index is up nearly 20% since that speech and sits above the level it reached just before the collapse of Lehman Brothers in 2008.

We have been critical of QE2 in light of a trickier exit strategy for the Fed down the road, but we have also felt it would be a powerful driver of stocks in the near-to-medium term.

Don't fight the Fed

I had the great pleasure of working for famed money manager and market timer Marty Zweig for my first 13 years in the business. One of the most famous lines he coined was, "Don't fight the Fed." Someone ought to tell that to the bond market. Since the Fed officially announced QE2 on November 3, Treasury bond yields and the US dollar have both shot higher—quite contrary to the Fed's intention (stated or otherwise).

In the chart of 10-year Treasury yields below, you can see that yields did move lower after Bernanke telegraphed his QE2 intentions in August, but since the actual announcement, they've shot higher. This is not necessarily distasteful to the Fed if it shows that inflation expectations are rising, but real yields remain low.

Upside Breakout in Treasury Yields

Click to enlarge
Source: FactSet and the Fed, as of December 13, 2010.

As regular readers of our work know, though, higher bond yields have not come as a surprise to us. Although we have been hesitant to use the term "bubble" to describe the government bond market, we have been clear in our warnings that a rise in yields, which in turn means a fall in prices, was very likely. This is due in large part to the traction the economy seems to be gaining—less about inflation risk, which remains fairly benign for now.

But it's also probably about a reallocation by investors from bonds to stocks. A vast amount of investment flows have been guided by the assumption of a status quo of low Treasury yields, rising commodity prices and a falling US dollar. The status quo may be no longer.

That said, Treasuries may be oversold in the short-run and we could see a reversal, if only from a contrarian sentiment perspective.

I would keep a close eye on the spread between the 10-year yield and the fed funds rate. As of today's close, that spread is 3.45%. During the past 25 years, there have been six periods when the spread approached 4%. It never broke above 4% and almost every time it approached that level, bond yields declined to narrow the spread again.

If this time is different, and the spread breaks out above 4%, it will be sending a strong signal to the Fed that it needs to begin thinking about tightening short rates.

Economy gaining traction
The recently announced compromise on taxes, which also included a surprise payroll tax cut and immediate expensing for business investment, has boosted assumptions for 2011 US gross domestic product (GDP) growth.

In addition, today's economic releases support the view that the economy is gaining strength. November's retail sales rose 0.8%, above the consensus forecast of 0.6%. Sales excluding autos jumped 1.2%, which was double the consensus, and October's sales were revised up by 0.5%. Core sales (excluding autos, gas and food) rose 9.1% in the three months through November compared to the prior three months. Happy holiday shopping!

In addition, the much-beleaguered small-business sector is getting into the holiday spirit. The National Federation of Independent Business (NFIB) index of small business sentiment rose to a three-year high of 93.2, from 91.7 the month before.

Small companies employ half the US workforce and their lingering despair (until recently) explains the anemic job growth we've seen to date. Add to that the recent loosening of credit standards and we may have a recipe for better job creation and capital spending.

This recent good news follows several notable improvements:

• A downside breakout in initial unemployment claims.
• University of Michigan and Manpower surveys showing significant increases in hiring plans.
• A better-than-expected October trade deficit, which should boost fourth-quarter 2010 GDP by 1%.
• Conference Board and Economic Cycle Research Institute leading indexes both well back into expansion territory.

Yields and stocks: symbiotic for now
The question now being asked is, "Can stock prices continue to rally alongside rising Treasury yields?" After all, it's generally taught that rising yields means falling stock prices and vice versa. That's not always the case, though, and we happen to be in a relatively rare period during which yields and stock prices have actually been positively correlated. You can see this relationship in the chart below.