There is a discrepancy growing between bond and stock markets. The bond vigilantes are betting the Fed is nowhere near done hiking rates. Stock jockeys disagree. Which camp will prove correct?

 

A look at the government's U.S. Treasury bond auctions this week resulted in most yields going higher. Buyers insisted on higher returns to purchase the billions of dollars in U.S. Treasury notes, bills, and bonds that are a weekly occurrence in the financial markets.

 

Overall sentiment in the markets has turned cautious and, for some, downright bearish once again after the January rally in stocks. Recession fears are once again taking center stage for many although there is still not enough evidence to prove it definitively.

 

Fourth-quarter Gross Domestic Product (GDP), for example, increased by a downwardly revised 2.7 percent annualized rate from the 2.9 percent pace reported last month. Slightly lower, yes, but the point is that GDP was still growing. And once again, the number of Americans filing new claims for unemployment benefits fell last week. The week-after-week decline continues to point to a persistently tight labor market in a growing economy.

 

The Personal Consumption Expenditures Price Index (PCE) for last month came in hotter than expected. PCE rose 0.6 percent and 5.4 percent year-over-year. Even after you strip out food and energy, core PCE rose 0.6 percent from 4.7 percent last year. The Commerce Department also showed that consumer spending rose 1.8 percent last month after falling the previous month and personal income rose by almost 1 percent.

 

Given the most recent macroeconomic data, it is hard to dispute that the economy is still growing, the decline in inflation is at least pausing, and that leads to the fear that the Fed may be at least thinking about increasing the amount of their next rate hike. 

 

This data is telling the bond market that the Fed may still have a long row to hoe before inflation gets back to the 2 percent target. They are certain that the central bank's tough interest rate regime will continue for much longer than the equity markets believe. Many analysts are beginning to think that the Fed funds terminal rate of interest could rise from its present range of 5.00 percent -- 5.25 percent to as high as 6 percent. It is the main reason that yields are rising, and bond auctions are suddenly problematic.

 

Over in the equity markets, these data points have taken some of the wind out of the sails of the bulls. The S&P 500 Index had a bad week, as did the Dow, NASDAQ, and the small-cap Russell Indexes. If the S&P 500 drops below the 3,950 level then we may see a decline into the mid-3,850 area.

 

As I wrote in my column this week, short-term, U.S. Treasuries are looking interesting for those who are sitting on a large amount of cash. In a down equity market, a 5.09 percent yield on a six-month Treasury note, or a 5.13 percent yield on a one-year Treasury bill is nothing to sneeze at. Investors are now receiving a yield equivalent to what equity investors can receive from the S&P 500 Index.  Granted, there is some interest rate risk if the terminal rate on Fed funds does rise to 6 percent. 

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.