Wednesday, April 29 is likely to be a day of fireworks for the financial markets. Equity indices have been chopping in a range for a few weeks, with the rally refusing to die, confounding market pundits.
However the price range has been contracting and it is likely that the indices will make a big move, either up or down
after the Fed announcement.
While equities have chopped around, yields in the treasury market have crept up and are now at the level seen prior to the Fed’s quantitative easing (QE) announcement last month.
While bulk of the attention has been focused on the equity markets, it is the action in the credit markets which are perhaps more critical to economic recovery.
What to Look for: Renewed focus on Quantitative Easing
The Fed will make observations about the state of the economy and their expectations of future growth. However much of this view has already been telegraphed by Chairman Bernanke over the past few weeks.
There should be no surprises there; it is the market intervention on the credit side which will be the focus of the markets.
The rally in the equity markets has made many market participants confident of shorting
the treasuries which has helped push yields higher.
The added supply of new treasury issuance to fund the spending campaign is also helping their cause.
The 10 year yield is above the 3% mark and the 30 year long bond yield is now approaching the 4% mark.
Ho wever,
this rise in treasury yields is threatening Fed efforts to engineer a turnaround in the US economy. Treasury yields are an important factor in determining interest rates across the credit market, including the all important mortgage rates applied to finance home purchases or refinance existing loans.
If treasury rates continue to creep higher they will have a significant detrimental effect on the home prices and put a damper on the recovery effort.
The market expects much higher yields further out in time. However, the Fed cannot afford to let the market get ahead of itself, and stall the recovery by pushing yields high too soon. That is why I expect the Fed to come out swinging in its efforts to talk yields down. The absence of a strong statement by the Fed will embolden treasury shorts and turbo-charge the rise in yields.
Equity Markets: Key off the Bond Market
Equities are likely to take their cues from the credit market after the FOMC minutes are released. A drop in yields will help strengthen the bullish case, since it will help drive economic recovery. However, if the Fed fails to talk yields down, the equity market might weaken.
Note that typically equity and bonds move in opposite directions as investors rebalance their portfolios by selling one asset class and buying the other. However, we are in a unique period where a significant portion of investment portfolios are in cash. As a result this negative correlation is not a given; there is enough cash sitting on the sidelines to drive equities higher and also support the credit market.
Though cash continues to be the largest holding in my portfolio, I have added some bond exposure by buying the TLT ETF over the past few days, in anticipation of the Fed making renewed efforts to cap the rise in yields. I do have concerns that the Fed may not be effective enough in talking the yields down, which is likely to lead to further selling of bonds, and much higher
yields.
I also hold some puts on the IYR and IWM in my trading portfolio, as a hedge against a drop in equity prices which might result if yields continue to jump higher.