Stock and bond investors can’t agree on what the Fed will do next

December 23, 2014, 6:54 PM UTC

A loose reading of the Fed’s lips could sink some investors’ ships.

The Dow Jones Industrial Average is up by more than 800 points since Federal Reserve Chair Janet Yellen spoke about the economy last week. Tuesday’s report that GDP rose at a 5% pace in the third quarter helped as well. It seems a majority of investors think the Fed’s message was loud and clear: We’re going to wait even longer to raise interest rates.

That’s a big deal. Higher interest rates usually lead to lower stock prices. So investors have been watching the Fed, which has held short-term interest rates close to zero, like a hawk. If the Fed is indeed putting off raising short-term interest rates—perhaps because of an economic slowdown overseas, economic turmoil in Russia, or because of lower oil prices—then that’s potentially good news for the stock market.

But here’s the problem: Stock market investors may have misinterpreted the Fed. At least, that’s what the bond market is suggesting. The yield on 3-month U.S. Treasury debt, after initially falling after the Fed’s meeting, has gone from 0.01% on Wednesday to a recent 0.04%. Granted, that’s not a huge move—just 0.03 percentage points—and 0.04% is still pretty close to zero. But if you think interest rates are going to stay low, it’s a move in the wrong direction.

The same was true in the futures market, where traders place bets on what they think the Fed’s rate will be. As of Friday, the prediction had increased to 0.28% by next July. Again, that’s not up significantly from the 0.255% it was a week before. But it’s the direction that matters. And it also means that bond market traders believe we’re likely to see at least a quarter point hike in interest rates by the middle of next year.

Of course, short-term interest rates may be on the rise for another reason. The Fed has recently been experimenting with reverse repo transactions in preparation for when they have to raise interest rates. That’s caused more volatility in short-term interest rates. What’s more, the 10-year Treasury rate is up by just 0.1 percentage points since Wednesday, to just over 2.2%. If investors really thought interest rates were headed upward, you would expect longer-term rates to jump by a lot more than that. Also, in general, a stronger economy leads to a higher interest rates, with or without Fed involvement.

Still, combine the indications of the short-term bond market with today’s 5% GDP news and you get the sense that stock traders betting on low interest rates for longer periods of time may soon have to bail out.

Read More

CryptocurrencyInvestingBanksReal Estate