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Farrell: Average Shouldn't Rally The Market

The focus of my notes this weekhas been on the bond market and the remarkable back-up in yields. The auctions earlier in the week of new 2- and 5-year bonds went well, with good bid-to-cover ratios. But that is not the worry, as short maturities have been and will likely stay in demand, as US paper is still more certain than pretty much anything else. The worry is the longer maturities.

The question is: Will enough buyers show up with the specter of the huge deficits and the constant need for financing hanging over the market?

The seven-year auction went well enough Thursday, with a bid-to-cover ratio of 2.26 to 1, in line with the past three auctions. About 33% of the deal went to foreign buyers, which is just below the average of the most recent seven-year offerings. In other words, it was just an average auction and not a reason for the equity market to rally. There was, according to my pal Art Cashin, better news out of the California housing market, but my best guess is the better tone to the market on Thursday had more to do with end-of-the-month biorhythms. The focus next week will be on the 10-year and 30-year bond auctions, and as they go, so will the equity market, is my guess.

Bill Gross was on CNBC commenting that a yield of 3.7% to 4.0% would be a good entry point for 10 year buyers. I bow to his greater wisdom on this, but I note that is a far cry from the less-than-3% yields of just a few weeks ago. Remember, the mortgage market keys off the 10-year, and a higher 10-year means higher mortgage rates. Higher mortgage rates put a serious dent in the Administration's plans to reinvigorate the housing market.

The papers noted in bold headlines the difference between the 2-year note and the 10-year bond is a record 2.75%. That is very good news for the banking system since they borrow at the short end of the market and loan money on longer terms. The difference, Net Interest Margin, is the profit, and a widening margin is a very good sign.

What is not a good sign is the rising TIPS spread. That is the difference between regular 10-year Treasuries and Inflation-Protected 10-year Treasuries. It is now around 1.87%, which is not at all bad in and of itself. The average the past few years has been more like 2.4%. This is read as the expected rate of inflation for the next 10 years. 1.87% is mild, but the move upward during the past few weeks has been dramatic. Two weeks ago it was 1.48% and last week 1.68%. The rising fear of inflation is to be watched very carefully. The Fed may try to enter the market aggressively at some point with massive buying programs to temper the rise in yields. Then again, they may not, since if it's a showdown between the market and the Fed, and the Fed is perceived as losing, that would be big trouble. They may just lay back and let yields reach their own level. I find it hard to see that scenario as positive near-term for equity prices.

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