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Market Lab Report - Update on rising bond yields vs stocks

Despite the impending passing of the next stimulus bill, more stimulus can be inflationary but at the same time, the Fed has set their target to average 2% thus at times, will go beyond this 2% with more bond debt issuance. Their recent Fedspeak on their concerns on being behind the inflation curve is a yellow flag that the Fed may raise rates sooner than expected. Still, over the last decade, when Powell starts to take a more hawkish stance, threatening to take away the punch bowl,reverses his position, putting the punchbowl back in place, with even more punch than before, after markets have fallen.

So markets could find a floor this week as a consequence. The new stimulus package (that the House will likely pass this Tuesday then Biden to follow) will pressure the Fed to buy more bonds thus this spike in yields on the long end of the curve should roll back over as they have been in a loose downtrend since 2009. Still, bond yields could continue to climb attracting more money while pushing stocks lower thus stocks falling further. One scenario: bond yields continue to drive higher, stocks drop further, more stimulus comes which brings more inflation, more money flows to bonds from rising yields which does lower yields but stocks still drop further. At the "uncle" point for stocks, Powell does what he always does and stabilizes the market by saying more stimulus is on the way, thus rate hikes are further off. The 4% odds of a rate hike shown in the CME Fed Futures goes back to 0%, which puts a floor in the stock market, allowing the decade long QE-driven bull to resume.

That said, the "uncle" point could still be several percentage points or more away from current levels.

The Fed may even have to invoke Operation Twist again, or at least that was the market's hope at the recent Fed meeting. Fed members did discuss this possibility as some are still betting some form of the flattening of the yield curve will have to happen https://www.cnbc.com/2021/03/01/fed-policy-changes-could-be-coming-in-response-to-bond-market-turmoil-economists-say.html.

Some have said Op Twist is needed because it raises rates on the short end of the curve and provides stability on the back end while not expanding the balance sheet thus does not require banks to hold more capital. From the above link, “We believe no other Fed balance sheet option can address each of these issues as effectively. To be clear the Fed will twist to deal with market functioning issues, not economic problems.”

The Treasury's balance sits at about $1.43 trillion. That’s less than the proposed bill which means there’s more debt coming not to mention the Biden Administration has its eyes set on a massive multi-trillion infrastructure bill. Yet with yields rising, the FED hasn’t stepped in, and the U.S. needs buyers of its debt.

But in the meantime, Powell's words suggest tightening sooner than expected as reflected by the CME Fed Fund Futures, though odds are still at a scant 4% at their April meeting.

The day of reckoning may yet come at some point. Once COVID abates, life normalizes, and people start spending again given all the helicopter airdrops instead of hoarding what they can, we may get a huge spike in inflation over which the Fed will have little control. 1920s Germany is an interesting example where citizens at first hoarded capital so deflation first set in, but once consumer confidence rebounded and spending normalized, inflation soared.
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