Stocks vs. Bonds: Unhealthy Tug-of-War

Sep.28.06 | About: SPDR S&P (SPY)

FinancialRx submits: In a previous post I wondered if we were at a Fork in the Road, given the ramp in equities, despite a sharp drop in yields. Since then the broader market has flirted with 5-year highs, while the long end of the yield curve has plummeted (a drop of 75 bps in 3 months is absolutely huge). In a nutshell, the stock market is pricing in better than expected growth, yet the bond market is pricing in a sharp slowdown or even recession, not to mention a bold projection that the Fed will have to cut rates in the next year or so.

Bill Gross weighs in with a breezy AMEN!

Currently, PIMCO’s best 60/40 bet is a cyclical one that proposes that the Fed is done and ultimately will have to lower interest rates in order to restimulate an asset based/housing led economy that has been its primary growth hormone in recent years. With inflation leveling off at admittedly unacceptable levels and the domestic economy moving towards a 2% real growth rate or less in the next year or so, the Fed at some point in 2007 will be forced to cut short rates... The U.S. bond bull market, which began almost two months ago, remains in its infancy but the best way to play it is via durations above index and concentrated in the front-end of the curve.

Paul Volcker is not so sure:

"I am a little bit more worried about inflation" ...While the inflation rate isn't "high" or "running away," Volcker said, "it is kind of creeping up, and I am impressed by the degree of pressure, if that is the right word -- psychological pressure, political pressure -- there is not to do anything about it."

"A lot of people out there on Wall Street, and on Main Street, are operating on the assumption that nothing very startling will happen in terms of restraint" on inflationary pressures, said Volcker. "That is reflected in attitudes pretty broadly. But once people are convinced that that's the case, it can creep up, and the more it creeps on you the more difficult it becomes to do something about it."

Dallas Federal Reserve President Richard Fisher is on the same page:

Several surveys of business executives have been released in the past week, all of which underscore the slower growth beginning to prevail. This includes recent surveys of the manufacturing sectors of the megastate of Texas by the Dallas Fed; the survey of the smaller but nonetheless meaningful production of eastern Pennsylvania, southern New Jersey and Delaware by the Philadelphia Fed; the National Federation of Independent Business; the Business Roundtable; and Duke University’s Global CFO Survey.

Lumping it all together, I am reminded of Mark Twain’s oft-quoted quip: “Wagner’s music is better than it sounds.” The outlook for economic growth may well be better than it sounds. At the same time, the inflation dynamic may be worse than it sounds.

As I sit at the FOMC table, I continue to fret more about inflation than I do about growth. While I am well aware of the risks to economic growth, the history of inverted yield curves, and the ever present possibility of exogenous shocks in a politically hazardous world, the “balance of risk,” in my book, is still tilted to the inflation side of the equation.

Markets are known to enjoy uncanny predictive powers, with some suggesting lead times of as much as 12 months. But right now the stock and bond markets are more like nervous needles on data dependent gauges. Thus the stock market sees healthy business conditions for the current quarter, at the same time the bond market sees inflation "leveling off." It is unlikely that tug of war will remain in such perfect balance indefinitely.

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