Stock traders often think bond traders know something they don't -- that they're smarter, or more in tune with the macroeconomic story of the day. Over the past several months, stock investors have overturned that myth, rallying the major indices in the face of an inverted yield curve and betting on a soft landing for the economy. The stock market was right. The slowdown came and went with a blink in the third quarter of 2006. Inflation simmered down, and fourth-quarter growth estimates ratcheted back up on rising exports, a robust labor market and unbreakable consumer spending. So as the stock market rode Goldilocks' coattails to more new highs this month, the bond market tried to play leapfrog and get one step ahead: Bond traders are concerned about an overheating economy, inflation, and possible fed fund rate hikes. The 10-year Treasury note broke down in price and broke through a key technical resistance yield level of 4.85% Thursday to close at 4.87%. And, the stock market finally woke up, took notice and got worried. The Dow Jones Industrial Average slumped 0.9% Thursday to close at 12,502.56. The S&P 500 fell 1.1% to close at 1423.90 and the tech-heavy Nasdaq Composite shed 1.3% to close at 2434.24. "A 5% yield
on the 10-year note is right around the corner," says Marc Pado, chief market strategist for Cantor Fitzgerald. "It's about time the bond market selloff is starting to impact the stock market."
Bond yields have been falling as the fed funds futures market has all but entirely wiped prospects of a fed funds rate cut from the 2007 calendar. "There is a big re-evaluation going on now in the bond market with regards to the Fed," says Bill Hornbarger, senior fixed-income strategist at A.G. Edwards. "The fear is that the Fed is going to be more hawkish." Indeed, the pendulum swung Thursday to reflect the possibility of rate hikes this year. The fed funds futures market prices in 1% odds of a rate hike at the March FOMC meeting, according to Miller Tabak. The futures market prices in 3% odds for a hike at the May meeting -- down from 3% odds of a cut as of Wednesday evening. In the span of about eight weeks, the market has retrenched more than 30% odds of a cut in March and a total of three rates cuts in 2007. But Tony Crescenzi, Miller Tabak's chief Treasury strategist and a RealMoney.com contributor, notes that if odds of a rate hike tick up to 20% or 30%, the bond selloff would get much worse, and so would the equity market reaction. He also characterized Thursday's move as an "unfriendly" selloff. It wasn't sparked by relief that there's no recession. Rather, it was sparked by fears of inflation and rate hikes.
As of now, the 10-year note has retraced 50% of its initial drop from its July 2006 high of 5.25%. The 4.85% level was the 10-year's 200-day moving average for yield, and a level the market had been unable to penetrate since last summer. The market rallied back after testing 4.85% in intraday trading in both August and October of 2006. Traders also note that foreign demand for longer-dated Treasury bonds may be starting to wane. Foreign buying by central banks and private institutions (including OPEC nations that collect oil revenue in dollars) has been another key factor that has helped keep interest rates low and fueled the stock market's rally. Indeed, the five-year Treasury note auction Thursday reflected weaker-than-average demand from foreign buyers, notes Pado. Over recent weeks, Asian bidders stepped in to buy bonds when the 10-year yield reached 4.80% intraday. That bid hasn't come through this week. Overall, higher bond yields drive up the cost of borrowing for both consumers and corporations, slow the economy, and hurt profits and overleveraged people and businesses. In the case of this economic cycle, low interest rates have kept corporate defaults extremely low, consumer credit conditions amenable and liquidity plentiful. Under the shadow of interest rate woes, earnings season looks even less sparkling. Investors have been coping with weak guidance from many of America's chief executives, and the fourth quarter is shaping up to break the streak of 13 quarters of double-digit earnings growth.
Ford ( F) reported its worst quarter ever and a massive $12.7 billion loss for 2006 Thursday. The bad news must have been priced in, as Ford's shares rose 0.25%. Homebuilder Beazer ( BZH) reported dismal earnings and a bleak outlook for the future Thursday, which propelled the homebuilders well into the red Thursday. Beazer fell 5.6%, while Toll Brothers ( TOL), Ryland ( RYL), Pulte Homes ( PHM) and Centex ( CTX) each slid 3% or more on the day. "At this point, we have yet to see any meaningful evidence of a sustainable recovery in the housing market, although we would expect to gain a better read on the market as the traditional spring selling season gets underway," said Beazer CEO Ian McCarthy, in a statement. Qualcomm ( QCOM) fell 1.2% despite beating earnings estimates. Lockheed Martin ( LMT) gained only 0.3% on a strong quarter and declaration of a dividend. One of the day's few bright spots was eBay's ( EBAY) move following a stellar earnings report Wednesday. eBay gained 8.2% Thursday. Also, Nokia ( NOK) jumped 4.5% on its earnings report, which helped push 2006 cell-phone shipments over the 1 billion mark, according to reports. Amgen ( AMGN) and Microsoft ( MSFT) reported earnings after the closing bell. Amgen disappointed investors, sending its shares down 1.8% in recent after-hours trading. Microsoft beat earnings and revenue estimates and blamed late delivery of its new operating system Vista for its profit drop. After falling 2.1% during Thursday's session, Microsoft's shares were up 3.4% in after-hours trading. If you still don't trust bond traders, another measure reflected the burgeoning anxiety in the markets Thursday. The VIX or volatility index, the so-called fear index, peeked out from the sand. After reaching lows under 10 last November, the VIX surged 13.5% Thursday to 11.22.