ZERVOS: Markets Are Starting To Worry About A Fed Mistake

Jefferies Chief Market Strategist David Zervos thinks markets are pricing in the possibility that the Fed is making a policy mistake in beginning down the path of monetary policy normalization too soon.

His evidence: rising short rates, low long-term rates (suggestive of little inflation), the rise in value stocks, and outperformance in emerging markets relative to US equities.

In a note to clients, he specifically points out the following:

1. The extraordinary demand for durated fixed income: 30-year yields are down nearly 50 basis points in 2014.
2. The rise in short-end yields: 3-year yields have risen 15 basis points in 2014.
3. The sharp recovery in emerging markets: EEM has rallied 8 percent in the last 6 weeks while spoos have gone nowhere.
4. The sharp outperformance of value stocks to growth stocks: IBB is down 18 percent in the last 6 weeks while IBM is up 6 percent.

He gives the first two points - which together represent a flattening of the Treasury yield curve - the most attention.

The spread between the yield on the 30-year Treasury note and the yield on the 5-year note has fallen substantially since the end of November. A large portion of the spread compression happened in reaction to two events: the Fed's decision to begin winding down its large-scale asset purchase program known as quantitative easing on December 18, and Janet Yellen's first meeting as Fed chair on March 19, which coincided with the release of forecasts by Fed officials that anticipated earlier rate hikes than before.

"Maybe these are just so-called 'position unwinds,' as some suggest; however, I would argue that something more fundamental is occurring," says Zervos.

"To be sure, it is difficult to tell, but if we dig a little deeper into the nooks and crannies of the 2014 price action, I think we see a market that is very concerned about Fed tapering. A market that is unsure about the Fed's ability to exit QE gracefully. And a market that is pricing in the potential for a future monetary policy mistake."

The drop in yields in the "long end" of the curve this year has raised concerns that in winding down stimulus too soon, the Fed is giving up on its goal of reflating the economy.

"As the market prices in higher short-term yields and lower long-term yields, it is really making a bet that the Fed, by tapering our punchbowl drip, is increasing the risk of deflation," says Zervos.

"And at this stage of the game, with inflation BELOW target and plenty of slack in labor markets, that could very well be a mistake. The most important point here is to recognize that low long-term yields are not a sign of a healthy economy."