In my last commentary, Is Intel Telling Us Something?, I mentioned a simple pairs trade—short bonds and short stocks—as a way to play the disconnect between Treasury yields and stock prices. Unfortunately, those who agreed with that simple logic and are in the trade now are starting to feel the pain as the typical correlation between stock prices and bond yields continued to break down, as shown below.

Last week, stock and bond prices moved in the same direction, with the S&P 500 gaining about 20 points while yields on the 10-year note compressed another 8 basis points to 2.82, stretching the rubber band further.

The easiest explanation for this is, of course, the speculation that the Fed has plans to basically pin down yields on the long end by buying Treasurys with the runoff from their MBS portfolio as bonds mature and are prepaid. Goldman Sachs’ economics team recently put out a piece explaining why it thinks this will amount to another $1 trillion in quantitative easing—the so-called QE2—with an announcement coming as early as this week’s Fed meeting.

If this speculation turns out to be true and the Fed does plan on manipulating the long end of the yield curve, as Bernanke suggested in his 2002 speech titled Deflation: Making Sure "It" Doesn't Happen Here, then the pairs trade could face a tough road ahead.

It would also be another example of the Fed messing with Mother Nature. Bond prices usually move down when stocks move up. That means yields move up with stocks, as they are both logical indications for future growth of the economy.

It’ll be interesting to see if Bernanke is able to maintain a drop in yields with a rising stock market for any length of time. Just thinking about that dynamic, even for the Fed, makes me think of the old adage “markets can stay irrational for longer than you can stay solvent.”

However, what the Fed doesn’t want to happen as a side effect of any “QE2” plans is to see the yield curve flatten to any meaningful degree. This would have a direct impact on future earnings potential at banks due to an ultimate reduction in their net interest margin.

Looking at a chart below shows the yield curve reverting back to September 2009 levels, with a looming possibility of more flattening, given the current decline in long-term yields.

It’s not that interesting that the curve peaked out earlier this year from historic steepness. The curve peaked out at similar levels in both 1992 and 2003 from similar levels. But it is interesting that it has been a bull flattener trade that has gotten us here today versus a more typical bear flattener that was at work in the previous examples.

Even with the yield on the two-year note setting record lows, the long end is still rallying hard enough to cause the curve to flatten out. This seems to be another consequence of zero-percent rate policy, as Japan experienced a similar phenomenon in the mid-1990s.

What If …

Playing out this scenario, assuming the Fed succeeds in achieving low, steady inflation and a smooth recovery, what then?

If the economy starts to return to “normal” and the idea of raising short-term rates starts to make more sense, how fast will the curve flatten? My guess is pretty quickly, and that would be close to a best-case scenario, in my opinion.

And the worst outcome? As is always the case, the main risk in any policy initiative is that the central bank is putting its own credibility on the line. If the Fed’s “QE2” fails to inflate the economy and deflationary forces sink their teeth in, it could mean the Fed has run out of ammunition.

Rates would stay compressed not because of the Fed buying Treasurys, but because they are behaving exactly as they are supposed to, given the deflationary economic backdrop.

For this reason, the Fed will probably “baby-step” its next move, as Goldman put it in its note. Why go for broke when the stakes are so high? If things don’t exactly pan out, it would give the Fed the opportunity to say it could have gotten an “A” on the test, but that it ended up with “C” because it could have tried harder. It’s all about credibility.

Regardless of what’s said or not said at this week’s Fed meeting, the message that comes out has now become more important, since the market is expecting some clarification. It should also provide some evidence as to what approach Bernanke will take in executing the next round of QE, if that is in fact what the Fed is planning to do. At this point, no action is an action.

Disclaimer: All data and information provided in this column are for informational purposes only, and should not be regarded as recommendations to buy or sell securities.

All charts created with StockCharts.com. StockCharts.com Inc. All rights reserved.

Chadd Bennett is a trader and former financial adviser specializing in fixed income. He worked at Bear Stearns when it collapsed, then joined Morgan Stanley Smith Barney.

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