The market is in harmonious disagreement with itself. Volatility is low and there are a lot of mixed messages throughout the landscape. Here is a quick recap of the market since January 1st :
-The Fed Funds rate is up 25bps
-The 10yr Treasury and mortgage rates are down 25bps
-All stock indices are up 7-15%
-1/3 of stock gains are from 5 companies
-The price of oil is down
-The price of gold is up
-The odds of a June FOMC rate increase is currently at 90%
The Fed is in a predicament.The post-election stock surge is running on fumes. Five stocks continue to move higher pushing up major indices but look at long term Treasuries. They are down 25bps this year; and that’s with the market also believing the Fed will raise rates three times this year. Three moves higher are basically a guarantee if you ask just about anyone. See graph below that compares the 10yr Treasury versus the odds of a June Fed raise. There is a big disconnect between longer dated bonds and the FOMC. Rates are moving down as the odds of an increase to rates goes up. Makes sense?
This week’s inflation figure, Core PCE, was only 1.5% year over year through April versus 1.8% in February. But the market is trading as if the number came in at 1.9%. By the way over the last 6 years that there wasn’t a single instance where year over year inflation dropped this much and popped right back up. Is the FOMC kidding themselves? Some FOMC members are concerned about inflation while others are pointing to the labor market and the fact that the unemployment rate is 4.4%. The logic being a tight labor market will push inflation higher eventually.
With the fast approaching June FOMC meeting, there hasn’t been a single instance when the market has priced in at least a 75% probability of a Fed move and they didn’t raise rates. Current pricing at 90% probability means the Fed would have to be somewhat foolish not to raise on June 14th, at least as far as history is concerned. If they didn’t move, that could spook the market and trust me, this is a market that doesn’t want to be spooked by the Fed. The new administration would certainly target the Fed if they caused any disruptions.
And that all leads us right back to this Friday’s jobs report. A tightening labor market might further the Fed’s argument that they can ignore recent disruptive inflation data. However if the unemployment rate goes up and job gains weaken then it does open the door for the Fed to back away from this game of chicken over inflation. The only other escape pod for the Fed is if the market digests the jobs data and backs away from a June increase. That would let the Fed off the hook. But as of now the fact remains that the Fed has painted either stocks or bonds into a corner and one of them is about to get a cold shower.