Updated: 01-14-2019

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Updated: 10-Jan-19  05:29PM ET
Analyst: Pat O'Hare

The Federal Reserve is going to be patient with its policy approach -- so said Fed Chair Powell and some other Fed members. Additionally, Mr. Powell conceded that the Fed wouldn't hesitate to make a change to its balance sheet normalization program if necessary.

Those admissions were music to the ears of the stock market, which was desperate for the good old days of the Fed put. Stocks have rallied sharply since those comments hit the wires on January 4 while bonds have sold off.

The reaction in the Treasury market seems counter-intuitive at first blush.

After all, if the Fed is going to be patient with its policy approach, implying that it is unlikely to raise the target range for the fed funds rate anytime soon, then the 2-yr note shouldn't be weak. Furthermore, if the ability to be patient is linked to concerns about a potential economic slowdown that should presumably keep inflation in check, then the 10-yr note shouldn't be weak.

The 2-yr note and 10-yr note have been weak of late, however, because stocks have been so strong. In other words, the risk-on mentality that has come back to the stock market has triggered some rebalancing that has turned off the risk-off flow of funds that benefited the Treasury market greatly during the December rout for stock prices.

Something else that has been weak since the Fed Chair Powell shared the happy policy talk with the stock market is the U.S. Dollar Index. It has slipped 0.8% to 95.55.

The dollar has reacted to the more temperate Fedspeak and so has the euro and the yen. They have gotten stronger since January 4 on the notion that the Federal Reserve is no longer sounding distinctly hawkish, which makes the European Central Bank (ECB) and the Bank of Japan (BOJ) seem less dovish than before without having said anything.

In other words, there is less concern about the Fed raising rates further at a time when neither the ECB or BOJ is entertaining a rate hike of their own.

If the euro and the yen keep strengthening, however, the idea that the ECB and BOJ will one day raise their policy rates is apt to get pushed back even further since the stronger currencies should help hold down inflation pressures, if not contribute to a trend of disinflation.

Ironically, the interest rate differential trade that has contributed to the recent strength in the euro and the yen could ultimately reignite the interest rate differential trade that has helped suppress long-term rates in the U.S.

The thinking being that long-term rates in the EU and Japan, which are still extremely low, should remain depressed if disinflation takes root and pushes out the prospect of a rate hike from either the ECB or the BOJ.

Currently, the spread between the 10-yr note and the 10-yr German bund is 254 basis points. The spread between the 10-yr note and the 10-yr Japanese government bond is 271 basis points.

Those spreads are narrower than where they stood a few months ago when stocks were selling off and there was an increased fear of the Fed getting too aggressive with its policy. Strikingly, though, they are noticeably wider than they were at this point a year ago when the U.S. economy was expected to get a big boost from the fiscal stimulus plan and when it was thought the Fed had a good bit of tightening room ahead of it.

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