Wednesday, March 14, 2018

Don't Forget About Bonds

Remember when everyone was worried about 10 year yields breaking 3%, which would hurt stocks?  Quietly, the bond market has settled down and is slowly flattening, which all things being equal, is a more bullish sign for bonds than a steepening.  When bond investors are more willing to buy duration, it means that they are more committed to deploying funds.  

Looking at Fed funds futures, currently the Jan 2019 futures is priced at 97.85, which implies a Fed funds rate of 2.15% on Jan 31 2019.  Given the current range of 1.25-1.50%, that is basically 3 rate hikes this year.  If you go out further to Jan 2020 futures, its 97.48, implying 2.52% on Jan 31 2020.  So 1.5 hikes priced in for 2019.  Beyond 2020, the curve is basically flat.  So the market is pricing in a terminal Fed funds rate of 2.50%, while the Fed forecast is 2.75%.  I believe any rate above 2% will be too tight for this economy and will quickly lead to an inversion of the yield curve. 

The pricing in the short term interest rate markets seem too aggressive, and assumes that the Fed will keep hiking even with the economy slowing down or if stocks start correcting.  I doubt that this Powell led Fed will just keep hiking if stocks are in a downtrend.  The market is pricing in a hawkish Fed and it would be surprising if they actually went through with 4 more hikes in this hiking cycle.  I would lean bullish on bonds, and that should help stocks in the medium term.  

Yesterday's gap up was a short term shorting opportunity on "Goldilocks" CPI and the market promptly obliged by selling off from SPX 2800 resistance.  There seems to be too much optimism in the short term, so there is room for a pullback down to 2730-2740, the pre nonfarm payrolls levels.  But this market is now back in an uptrend and weak hands seem to be mostly out, so it could just grind higher to 2870 by April without a bigger dip.  I would rather be buying dips than shorting rallies for at least the next 4 weeks.

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