Bond Investors May Be Forcing Fed to Cut Rates. What Does That Mean for Stocks?

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The difference between the two-year treasury yield and the federal funds rate is indicating that the Fed may want to cut rates sooner rather than later.

This may sound boring, but the implications for stocks are positive.

On Wednesday, the Federal Reserve said it would keep interest rates steady. That was the expected outcome, as economic data have been positive in the past several months. GDP growth has been just above 2% and inflation has hovered just below 2%.

The economic outlook looks fairly positive for 2020, with the probability of a recession on a rolling two-month basis moving from 35% in the third quarter of 2019 to 25% now.

The consumer — who is growing and maintaining U.S. GDP — remains confident. Housing data have edged up. Manufacturing activity remains in contraction but accounts for just roughly one-third of U.S. output.

In addition, stocks have continued their run after an impressive 2019, moving up 1.32% to start the new year.

Investors are encouraged by all of the above, but they’ve also taken solace in the fact that the Fed has made clear it will provide stimulus if the economy needs it.

That stimulus could come sooner rather than later, according to both the bond market and one strategist’s interpretation of it.

The two-year treasury yield in the past 5 days has fallen to 1.42% from 1.53%. (The 10-year yield has also fallen.)

Not only does this not represent a classic “risk-on” market, where stocks and yields both rise, but the two-year yield is now below the federal funds rate (the rate at which the Fed lends to banks) of 1.5% to 1.75%.

"Two-year yields, which we view as a proxy for expected monetary policy, typically follow the fed funds rate unless fixed-income investors expected a rate change in the near term,” wrote LPL Financial strategists in a research note.

An LPL graph shows that all three rate cuts in 2019 were preceded by a slip in the two-year treasury yield below the fed funds rate range.

LPL doesn’t see the need for a rate cut “yet,” the firm stressed. That’s the way most on Wall Street see it: The probability of a rate cut in 2020 rose to 15% Wednesday from 12% earlier this week.

The Fed has “committed to a laissez-faire approach in 2020 and it looks like they’re sticking to their guns,” said Mike Loewengart, vice president of investment strategy at E-Trade, told TheStreet. "That said, growth and inflation will be two critical components that could interfere with their stated course of action.”

And one former Fed member warned on the growth and inflation front. "The durable-goods data that came out — even if you net out the Boeing BA effect — was much weaker than what was expected, and … the Fed will become increasingly concerned if it looks like the U.S. is not going to pull out of the industrial recession that it’s been in for several quarters now,” said Danielle DiMartino Booth, former adviser to the president of the Dallas Fed and founder of Quill Intelligence.

Durable-goods orders — orders of goods purchased not daily but rather sporadically — rose 2.4% in December from a month earlier. This was weaker than expected, even when excluding Boeing’s negative impact on the total number.

Manufacturing activity has been declining on a year-over-year basis since August 2019, dragging on an overall satisfactory economic growth picture in the U.S.

Should the Fed need to cut rates, the market may pull back. At 18.4 times next year’s earnings, the average stock on the S&P 500 is overvalued, according to some on Wall Street, as the economy is generally viewed to be late in its cycle. Many of those market participants and analysts are looking for a pullback.

But a pullback would likely be that and nothing more. If the Fed were to cut rates, equity prices would be supported, potentially muting the extent of a stock market drop.

In addition, earnings growth is now expected at 9% for 2020 and 10% for 2021, according to FactSet estimates. Plus, “equity bull markets rarely end in the absence of a recession occurring,” wrote UBS’s chief investment officer of Global Wealth Management Mark Haefele in a note.

While Haefele reminds investors that “the U.S. business cycle is in the late stage,” he also said “risks for the economy have eased. We are overweight equities.”