SHORT AND LONG-TERM RATES USUALLY TREND IN THE SAME DIRECTION -- LONG-TERM RATES APPEAR TO HAVE TURNED UP -- THAT COULD BE BAD FOR STOCKS

RELATIONSHIP BETWEEN SHORT AND LONG RATES ... With the Fed expected to keep raising short-term rates, a lot has been written about the relationship between short and long-term rates. The fact is that they usually trend in the same direction -- but not always to the same degree or at the exact same time. One sometimes turns before the other; but sooner or later, they start to trend together. Chart 1 compares the yield on the 3-month T-bill (monthly bars) to the 10-year T-note yield (red line) over the last ten years. You can see that they generally trend in the same direction, but one sometimes turns before the other. Long-term rates started dropping at the start of 2000 as the stock market peaked and money poured into the bond market. That pushed bond yields lower. It wasn't until the start of 2001, however, that the Fed started to lower short-term rates. Both fell together until the middle of 2003 when long-term rates (red line) started to rebound. In the middle of 2004, the Fed started to raise short-term rates. They've risen faster than long-term rates since then. But they now appear to be trending in the same direction -- upwards.

Chart 1

Chart 2

YIELD SPREAD SHOWS TIGHTENING ... Chart 2 is a ratio of the 3-month T-bill rate to the 10-year T-note yield. It shows a Fed tightening in the middle of 1999 (in reaction to rising oil prices) which contributed to the market peak the following year. The dramatic drop in the ratio starting in early 2001 was the Fed's way of fighting the stock market collapse and the threat of global deflation by aggressively lowering short-term rates. The ratio started rising again in the middle of 2004 as the Fed started its current campaign of raising short-term rates. A rising ratio has historically had a negative impact on the stock market -- especially when short and long-term rates are rising together -- as they appear to be in Chart 1.

BOND YIELDS VS. THE S&P 500 ... Chart 3 compares bond yields (red line) to the S&P 500 since 1995. Up until 2000, the rule of thumb was that falling bond yields were bullish for stocks and rising rates were bearish. Bond yields fell from 1995 to 1998 which supported the stock market advance. Yields rose during 1999, however, which led to the bursting of the stock market bubble in 2000. [Historically, bond yields bottom (and bond prices peak) before stocks do]. The relationship between bond yields and stocks changed from 2000 to 2003. The deflationary nature of the stock market decline caused bond and stock prices to "decouple". In other words, bond prices rose as stocks fell. Since bond yields fall as bond prices rise, that meant that bond yields and stock prices fell together during the secular bear market. Since the spring of 2003, however, their relationship appears to have returned to their normal historical pattern. In other words, rising long-term rates are starting to hurt stocks.

Chart 3

RISING RATES HAVE BEEN HURTING STOCKS ... Chart 4 shows a more normal relationship between bond yields (red line) and the S&P 500 since the spring of 2003. The March 2003 market bottom saw a plunge in bond yields (first green circle). Another drop in bond yields starting in August 2003 (second green circle) supported another stock upleg. The third drop in bond yields in the middle of 2004 helped launch the market rally during the second half of last year (third green circle). Of more concern are the troughs in bond yields. The first one in June 2003 (first red arrow) caused a pullback in stocks. The second yield trough in March of 2004 (second red arrow) caused a correction in stocks. The third arrow marks the start of the latest upturn in yields. If that upturn in bond yields continues (and I think it will), that could cause problems for a stock market that's already starting to look toppy.

Chart 4

BOND YIELDS JUMP, STOCKS SAG AFTER FED ... The Fed raised short-term rates a quarter point today as expected. It also left its wording about raising rates at a measured pace unchanged. It did, however, admit that inflation pressures were rising. That had the initial impact of pushing long-term rates higher and stocks lower. Chart 5 shows the 10-year T-note yield jumping over 4.60% for the first time since last summer. That's not good for bond prices or stocks. We'll take a closer look at the market's reactions after the close today.

Chart 5