Why Bonds and Stocks Pull in Opposite Directions

Partly, it's because bonds have risen sharply enough to make traders sit on their gains.
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On the evening of Jan. 2, 1991, the first President Bush finally got around to saying the U.S. was in recession, a term he'd shied away from until then because it was perceived as "politically damaging." But by March the economy was growing again, and the joke got to be that once the president said the country had entered recession we were just about out of it.

Monday, the National Bureau of Economic Research got around to saying that the U.S. had slid into recession, and you've got to wonder if the recognized arbiter of business cycle dates might be pulling a Bush. One might guess as much by looking at the markets. Not only have stocks rallied spectacularly, but the fixed-income markets are pricing in expectations that the

Fed will be raising rates by the midpoint of next year.

Yields on long-dated bonds have remained (to the chagrin of the Fed and the Treasury) stubbornly high -- an indication that the bond market may be betting not just on an economic revival but perhaps a whiff of inflation. Meanwhile, the

fed funds futures market is pricing in a 1-in-2 chance the Fed will have raised its

target rate to 2.25% -- a quarter-point above where it is now -- by the end of April. By the end of May the futures market expects the funds rate to be at least 2.25%, with a strong possibility that it will be even higher than that.

The Amazing Receding Punch Bowl
Fed funds futures factoring in target rate increase

Source: Chicago Board of Trade; TheStreet.com

Uncertainty

What's strange is that it is very hard to find anyone who shares the market's apparent view that the Fed will begin tightening the screws so soon. "It's a little overdone," says Mike Cloherty, a bond market strategist at Credit Suisse First Boston. "There's still a tremendous amount of uncertainty out there. In that kind of environment, the Fed's not going to pull the plug."

Most economists agree. According to the most recent

Reuters

poll, only two of 24 dismal scientists think the funds rate will be above 2% by midyear. Most think it will be lower.

"I don't think that anyone believes the Fed is going to reverse policy so quickly, but the market continues to price it in," says Richard Gilhooly, bond strategist at Paribas Capital Markets.

So why the disconnect? One theory making the rounds is that so many fixed-income types already have had such a good year that nobody is laying down any major new bets. Through the end of last month, for instance, the

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Pimco Total Return fund (with $50 billion under management, the nation's largest) returned 11.2%. A great year, especially when you compare it to a (gasp) stock fund. Meanwhile, many bond traders have done well and are looking at (again, gasp) fat bonuses.

Bitter Irony

"If someone's had a great year, they don't want to risk losing their gains in the last month," explains Cloherty. It's a bitter irony that part of this unwillingness to take on risk stems from the Treasury's snap announcement last month to

stop issuing the 30-year bond. It was an obvious attempt to drive down long rates, but for now it has only made traders who might otherwise be buying bonds hold off.

The upshot is that once the fiscal year ends for bond portfolio managers and traders (for some this is Nov. 30, for others Dec. 31), the rupture between what the market seems to be saying and what most people in the market apparently think will be mended. There's a good chance Fed-tightening expectations will recede and yields on longer-dated bonds will come down. Stock market investors who have been citing bond market movements for their theories of a super-fast economic recovery may have a rude awakening. Bond investors, on the other hand, may be very happy clams indeed.