Stocks and Bonds Tell a Conflicting Story: Who Gets Burned?

With stocks and bonds rallying the last few weeks, market observers have begun to question what is really taking place, and who is right (or wrong).

While equities continue to show strength, treasuries and mortgages have rallied as well. Despite a large sell-off on Friday, the 10yr bond touched ~3.15% last week. Could there really be a sustainable demand for 10 year paper at 3%? Let's look at a few issues that should determine this going forward:

• Hanging on the Fed: the market, more than ever, is hanging on every word of Bernanke to decipher when they will start to tighten policy. I feel like I've heard that rates will stay low "for an extended period" has been repeated ad nauseum.
• Quantitative Easing: What affect will the ending of the Fed's purchases have on the bond market. By the end of the $1.5T program, they will own over 75% of current coupon (4.5%) mortgages. Despite the announcement of a soft landing, shouldn't bonds have sold off? That hasn't been the case. Who is it that the market's anticipating will soak up this demand?
• Inflation: The inflation/deflation argument is above my pay grade, but I will say that I am not aware of a time when this country has seen inflation without wage inflation. I recently read an article by John Mauldin stating that in order to get back to full employment in five years, and accounting for population growth, the US will need to produce an AVERAGE of over 250,000 jobs per month. He went on to state that we have never produced this many jobs on average over any reasonable time period.

If the job situation is so dire right now, why does the equity market continue to rally? After all, isn't Wall Street sophisticated enough to know that the "band-aids" of the new administration (8k home-buying credit, cash for clunkers) do not produce true sustainable job recovery?

Until we see a reason to believe that the job situation is showing significant improvement, it seems hard to believe that the Fed will tighten policy.

As we are at a time of historically low interest rates, many Banks and Insurance companies are afraid to get burned by going out on the curve. As they start to see that a true economic recovery is not within sight, I expect them to go further out on the curve. This should help bolster bonds in the short run.

Disclosure: Long FAIRX and TGLMX