Gravity is the one thing stocks and bonds have in common 

Prior to 2000, when the Fed began cutting rates to save the markets, equities and treasury bond interest normally went in opposite directions. It wasn’t until around 2000 that stocks and treasury interest began to move in lockstep in the same direction. Source: Lance Roberts, Real Investment Advice 

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If the Fed simply ended its massive QE, the market would tip right away, but the Fed is tapering its response to inflation, as we all knew it would. Inflation has now hit the level that is forcing the Fed to respond, as I’ve argued it would, and the Fed’s response will be a game changer, but it is a graduated response, so it has no clear tipping point. No bull can run uphill against increasing gravity forever, which means the market will have all the further to fall in order to catch down to reality. 

As the Fed tapers, bond interest will rise. The market is going to take interest higher on its own. This time the Fed is facing inflation that already matches the 70s. The Fed has nowhere to go to lower interest rates if things get bad. That will force the Fed to hold the new course it has set.

With interest rates low, investors have moved to take higher risk, but bond interest rates are now deeply negative in real terms, which really pushes the reach for yield and willingness to risk. We are, in other words, running our economy on the kind of high-octane monetary stimulus that is only applied in the worst of times, and times are about to get better as interest is rising. As the Fed relinquishes its death grip on bond interest, the pressure to reach for yield via. high-risk nosebleed prices in terms of what companies need to keep making will go away.

The Fed will switch from wildly negative real rates (negative net yield after inflation) to neutral or positive real rates. This is one of the main mechanisms by which inflation will clobber the stock market.

For bond funds, it’s all very bad news, as they make a lot of their money by speculatively buying and selling bonds.

The Fed may need to speed up the tapering of its bond-buying program after inflation surged and job gains picked up. Two-year yields on US treasuries soared on Friday, indicating the bond market is a sleeping giant that can be roused. The Fed has used bailouts, abnormally low interest rates and QE to fuel bull markets by removing risk. 

Now, even by its own pathetically re-engineered inflation measures, inflation is running three times hotter than the Fed’s target, so it must act. The Fed is acting, and it is talking about acting even faster, just one month past its decision to act. There will be a lag between the Fed’s moves to raise interest rates and the market’s response.

When the economy is falling so that earnings are dropping and bond interest is rising, stocks stop looking as interesting as they used to. Fed stimulus and low interest were driving the economy up or at least creating lots of money that had to get stored somewhere other than just in bank deposits while inflation was lying low. 

Now we have entered an environment that is entirely different from all of that because there is a tipping point at which inflation can largely be ignored, and we have reached that level. The Fed said inflation was transitory because it had to. It knows it cannot fight inflation without damaging the dependent markets it has built.

By Terry Grennon

Asset Allocation Strategist