A conundrum or just "steady as you go?" There appears to be no dilemma on the Fed’s plate, as they bumped the funds rate from 2.75% to 3.00% on May 3rd, but rather "a steady as you go" approach. This most recent action by the Fed represents a total of 8 moves of 25 basis points, starting late June 2004, when funds were rock solid at 1.00%. However, current bond yields are more reflective of an economy that is not overheating and seems poised for a break in continuous rate hikes going forward. So, the real question to ask: will this move to 3.00% be it for a while or will we be in for another 25 basis points when the Fed meets again on June 29th?

But first, a look at what the yield curve looked like back in June 2004 when funds were at 1.00% and on May 3rd with funds at 3.00% ( June 2004: 2’s=2.80%, 5’s=3.84%, 10’s=4.63%, and Bonds=5.32% vs. May 2005: 2’s=3.63%, 5’s=3.88%, 10’s=4.19% and Bonds=4.51% ) Or, more simply said: federal funds are higher by 200 basis points (bps), 2’s are up by 83 bps, 5’s are up by 4 bps, 10’s are down by 44 bps, and Bonds are shockingly down by 81 bps. From here, let’s make some observations on what we think the bond market is saying about the Fed and inflation.

Bonds are suggesting that the Fed has thus far done a masterful job in their effort to head off any fears of inflation as evidenced by the fact that the yield on both the 10 year and 30 year have failed to rise. Bond traders do not see inflation as an ominous problem or the yield curve would be significantly steeper, rather than a more normal upward sloping curve which signals that the economy is expanding but at a manageable rate. It’s important to remember that the Fed sets short term rates (Federal Funds) while the bond market sets rates on longer maturities.

If the Fed wanted to "cool" the economy from heating up as a result of higher oil prices, a weak dollar, and a worsening trade deficit, they should be pleased. Oil has dropped from $60 per barrel to $50 per barrel, the dollar has begun to improve, and the first quarter GDP came in at 3.1% followed by inflation at 1.6%. Although the trade deficit is worrisome, it will improve in tandem with an improving dollar, lower energy prices and higher short term interest rates.

Stung by high energy prices, both consumers and businesses were forced to curtail discretionary spending in the first quarter, causing the slowest economic growth rate in 2 years. The first quarter (up 3.1%) was the most sluggish since the first quarter of 2003. Spending on big ticket items were flat while investment in new plants and other buildings fell. Still, the high cost of oil poses a problem going forward and will strain household budgets well into the summer months.

So, what about the stock market? We keep reading reports that suggest that the stock market is too rich and dividends are too low. For reasons we can’t understand, there are a lot comparisons to the 1982 era when interest rates were very high, inflation had been off the charts, and both the stock market and the bond market were extremely volatile. Remember, the 2 year note was at 15%, the 30 year bond was at 14%, and stocks were yielding 6%. Looking back to 1982, the best trade was not 2 year notes but 30 year bonds and stocks as both had long term value. Today, investors can buy a basket of S&P stocks in the 3.5% range and match the 2 year note. So maybe stocks are not too rich, but in our mind down right cheap.

We believe that bank investment portfolio managers should be buying paper in the 2-3 year range. We particularly like callable bonds with 2 1/2 to 3 year maturities with 1 year / one time calls with yields upward of 4%. Also, it goes without saying: the easy trades are selling stocks, bonds, U.S. dollars, and buying oil. The hard trades are the opposite: buying stocks, bonds, dollars, and selling oil. Easy versus hard. You make the choice!