It's amazing how people can sometimes look at the exact same picture and see entirely different things. That's art we suppose, or maybe it's an NFT. Anyway, we digress.

It's also interesting how market participants can hear the same thing but have an entirely different take on what was heard. That captures the essence of the disparate reactions by the stock and Treasury markets to the latest FOMC decision and press conference.

Granted both markets seemed happily aligned in the immediate wake of those happenings, but subsequent behavior suggests things may not be so copacetic.

Change, No Change

What stood out for market participants were the summary projections for the economy and the target range for the fed funds rate. One changed considerably while the other didn't change at all.

The Summary of Economic Projections for 2021 showed an upward tilt to the median estimate for the change in real GDP to 6.5% from 4.2%, a downward tilt in the median estimate for the unemployment rate to 4.5% from 5.0%, and an upward tilt in the median estimate for the PCE inflation rate to 2.4% from 1.8%.

What didn't change at all, however, was the median estimate for the target range for the fed funds rate. That target range is expected to remain 0.00-0.25% through 2023.

In turn, Fed Chair Powell didn't change his commentary at all, not when you really look at it. He said (and we paraphrase):

Inflation rates will be picking up noticeably in coming months given low base effects, but any move above 2.0% is expected to be transient. I would be concerned by disorderly conditions in markets or by a persistent tightening of financial conditions that threaten the achievement of goals, but the stance of monetary policy we have today is appropriate. We think that our asset purchases, in their current form, are the right approach. We could change them in a number of different dimensions should we deem it appropriate, but for now we think our policy stance is appropriate. It is not yet time to start talking about tapering asset purchases.

In brief, he said for the umpteenth time that the fed funds rate isn't going up anytime soon and that the Fed is unlikely to be swayed by any scary-looking inflation data that could present itself in coming months.

In brief, what the stock market heard right after the FOMC decisions and press conference was: "Party on!" In brief, what the Treasury market heard was: "No need to worry about a taper."

On Second Thought

What the Treasury market heard initially and what it subsequently thought have turned out to be two different things. The subsequent thought was that "the Fed risks playing with inflation fire and we might get burned."

Accordingly, the 10-yr note yield, which moved down to 1.63% (from 1.67%) immediately after the FOMC decision and press conference, subsequently rocketed to 1.75% on some inflation-fear boosters.

That move is setting up to be an interesting test, not only for the Treasury market and the stock market, but for the Fed as well.

The coming months are likely going to produce some scary-looking inflation data. Fed Chair Powell suggested as much, citing base effects that play into inflation calculations (i.e., prices this year will be comping against much lower prices seen in the depth of the pandemic onset). In other words, the inflation data is going to look quite inflationary, but the Fed's view is that the scary stuff will only be temporary.

It will be a very interesting test, because market participants know some bad inflation data is coming, yet that doesn't mean market participants will necessarily greet it with the Fed's insouciant take on matters.

The fact that the 10-yr note yield moved so quickly to 1.75% after the Fed chair's latest remarks goes to show that it could end up being a trial by fire for the Fed in the Treasury market in coming months.

A Special Dispensation

If the Fed isn't acquitted by the price action in the Treasury market, the trials and inflation tribulations seem destined to spill over to the stock market via the interest rate channel. They have already to a certain extent, driving the underperformance of the growth stocks versus the value stocks.

The value stocks aren't exempt from the valuation pressures created by rising interest rates, yet they are being granted a special dispensation for now because the jump in long-term rates is also a byproduct of expectations for stronger economic growth. That stronger growth should lead to stronger earnings growth for these value plays, most of which face much easier comparisons and have seen consensus earnings per share estimates increase.

The latter has been an important component of their relative strength thus far in the face of rising long-term rates. Notably, despite a huge price increase for many value stocks since last November, the price-to-earnings growth ratio ("PEG" ratio) of 2.0x for the S&P 500 Value Index is the same as it was on November 1, 2020.

On a PEG basis, then, you're paying the same for expected earnings growth for the value stocks that you were on November 1.

However, the yield on the 10-yr note has gone up 90 basis points since November 1, putting a greater onus on these value stocks -- and all stocks - to live up to the heightened earnings expectations that have accompanied rising stock prices.

What It All Means

Fed Chair Powell sounds comfortable with letting the economy and inflation run hot. He even sounds comfortable leaving long-term rates alone. That could change, he implied, if the behavior of long-term rates leads to disorderly activity in the markets or creates a persistent tightening of financial conditions that get in the way of the Fed meeting its goals.

For now, he is steadfastly walking the party line with respect to the Fed's current monetary policy stance. The stock market looks content to keep partying on that line. The Treasury market, though, doesn't look so sure that it's a good idea to stick to the party line.

Inflation data in the coming months is going to be a test of the resolve of both markets. If the Treasury market fails to pass the open-book test that includes answers on inflation already provided by Fed Chair Powell, then the Treasury market just might spoil the stock market's party-like behavior.

--Patrick J. O'Hare, Briefing.com