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The Stock Market v. Treasury Yield Paradox, Resolved

The big market paradox of the past few months has been the differing signals coming out of the stock and U.S. Treasury markets. Stock prices have been roaring since early March, up over 50%. That should be a strong signal that economic conditions are on the upswing. But even though today's GDP report does show that the recession may have ended in the second quarter, Treasury yields have remained flat since the spring -- showing that there are some big doubts about the strength of a recovery.

But Paul McCulley at Pimco says that this isn't really any sort of paradox at all. He argues that the expansion of the Fed's balance sheet (and the additional risk-taking that entails), plus the central bank's commitment to keeping rates low, has helped fuel the asset price boom:

as long as the Fed retains ownership of its longer-dated assets, sterilizing their liquidity effect via reverse repos, the Fed will remain not just the arbitrator of the Fed funds rate, but will also be a holder of market risk previously borne by the private market.

Thus, while rich risk asset prices can certainly be viewed as a consensus expectation for a strong recovery, such lofty valuations can also be viewed as a consensus expectation about the Fed’s commitment to erring on the side of being too late, rather than too early, in starting a Fed funds tightening cycle. Indeed, one could actually be agnostic, even antagonistic, about a big-V recovery and still be favorably disposed to risk assets, in the short run. Historically, what pounds risk asset prices is either a recession or unexpected Fed tightening; or worse, both.

Which could mean, if McCulley is right, that bad things are in the offing for stocks if the Fed drops the "extended period" phraseology on low rates from its post-meeting statement next week.