Economic Analysis: Bond Rates Worry Equity Markets

The Treasury and corporate bond markets are beginning to worry and annoy the equity markets. Focus will be on interest rates as trading continues today and as traders try to gauge the Federal Reserve Board’s (Fed) next move towards policy normalization and hiking of interest rates.

There was a report from the staff of the San Francisco Fed which added to the nervous tension already in the air. It released a study that said investor expectations for a rate increase often lag behind the Fed. On top of that the Treasury market has been full of comments, rumors and innuendo that the Fed was getting ready to tweak its language by removing a key phrase which states they will keep rates ultralow for the foreseeable future. By removing the wording “considerable time” the Fed will create confusion and increase volatility. Removing that phrase could mean an earlier than expected rate hike. This will be key and volatile, not only for bon rates but in the equity markets as well.

The Fed is expected to end its current quantitative easing (QE) program this fall with the final act of tapering occurring next month in October. This is leaving the financial markets to start guessing when the first rate hike will come. Right now, we expect that to occur sometime in mid-2015.

There is a chance with a change of language during the October meeting as some believe the Fed should be focused more on the data. The Fed needs to move away from the calendar based guidance without causing confusion which will lead to re-pricing of financial instruments like Treasuries and corporate debt. Somehow, they will need to convey a strong message that a change in wording does not indicate an imminent change to policy.

Equity markets are hanging on to every word they hear from the Fed. Traders know if they overreact and make drastic moves, they could backfire. Traders do not want to be the source of market volatility so they are listening to the Fed. Maybe the Fed should make only minor changes to the wording, soften the language but make it clear rates will stay pat for some time to come. Next Wednesday, Federal Reserve Chair Janet Yellen will release her statement, and she will have a golden opportunity to explain any upcoming changes then.

Yesterday, Treasury notes rose higher, especially in the benchmark five year note. Prices shot lower and yields were up to 1.76 percent. A 2.68 percent increase. As rates inch higher, equity markets start noticing and there is a bearish undertone beginning to develop.