Equity and government bond markets appear to be taking opposite views on how effective the Federal Reserve's planned interest rate hikes will be at tamping down record inflation without toppling the economy.

U.S. Treasury yields, which move inversely to prices, are reaching their highest levels since 2019. The yield on the 2-year note, for example, settled at 2.35%, up 104 basis points in less than a month. The collapse in bonds is being met with a rally in equities. The S&P 500 settled March 29 up 11% from its recent low on March 14, while the NASDAQ Composite Index has rallied 16.2%.

The movements are reflecting skepticism in the bond market that the Fed's aggressive plan to raise interest rates, revealed earlier in March, will result in a so-called "soft landing" that will avoid shocking a recovering economy. Portions of the U.S. Treasury yield curve have inverted this month, a potential warning sign of a recession ahead. Stock investors, meanwhile, appear unbothered, with the S&P 500 just 3.4% below its all-time high.

"The bond market is very much convinced that the Fed is going to have to move too aggressively and that the economy will not be able to function properly on higher interest rates," said Patrick Leary, a senior trader with Loop Capital Markets, in an interview. "The stock market, on the other hand, seems less convinced about this whole thing."

Fed plans

Bond yields are largely reacting to the Federal Reserve's plans to address soaring inflation through historically aggressive rate hikes and reduction of its nearly $9 trillion balance sheet. On March 16, officials with the rate-setting Federal Open Market Committee approved an increase of 25 basis points to its benchmark federal funds rate and Fed officials forecast the rate, kept near zero since the beginning of the pandemic, would rise to nearly 3% by next year.

The Fed's plan to raise rates at a pace not seen since at least 2005 has caused shorter-term Treasury yields to soar, setting up likely inversion throughout the yield curve, where shorter-term yields rise above longer-term tenors. An inverted yield curve has preceded every recession over the past 50 years, making it a key predictor of a looming economic downfall.

The closely watched spread between the two- and 10-year yields briefly inverted on March 29. The gap between these two yields, which have not inverted since August 2019, settled at just 6 basis points on March 29. That gap was at 89 basis points early this year.

The surge in short-term yields and collapse in spreads will likely turn March 2022 into the worst month for the U.S. Treasury market since July 2003 and potentially the worst quarter on record, said John Canavan, a bond strategist for Oxford Economics.

The collapse will likely be confined to bonds, at least for now, Canavan said.

"Stocks have performed quite well this month despite the sharpness of the rise in rates and the potential economic risks suggested by the flattening curve," Canavan said. "We expect stocks will remain supported even amid the aggressive path for Fed rate hikes."

Market volatility

The differing paths of the two markets can be seen in their different volatility indexes, said John Luke Tyner, a fixed-income analyst at Aptus Capital Advisors.

In March, the ICE BofAML Move Index, the bond market's volatility index, surged to its highest level in roughly a year. The CBOE Volatility S&P 500 Index, a key stock market index, has fallen throughout much of March.

"Bond volatility is knocking on COVID levels while equity volatility is snoozing," Tyner said. "One of these markets is right."

It appears that the bond market is betting on a policy mistake from the Fed, while the stock market seems to believe that the central bank can effectively tackle inflation.

"Equity markets seem to believe the Fed can land the plane on a toothpick for the soft landing," Tyner said. "Even though there is a lot of bad news, nothing material has spewed over to current economic data that has been bad enough to spook [stock] markets."

Labor market views

Ongoing strength in the equity market likely has to do with a more optimistic view of the real economy, particularly continued tightness in the labor market and the 3.8% unemployment rate, Leary with Loop Capital said.

"It's really tough to have a recession when you have a less than 4% unemployment rate," Leary said.

Still, the stock market rally could be short-lived if the Fed's efforts to curtail inflation seem insufficient.

"I think the narrative here can change … if the market views that the Fed's tools are becoming ineffective against inflation and inflation expectations become unanchored," Leary said. "That could really derail this equity rally."

Further weakness is likely ahead for Treasurys unless inflation begins to trend lower, said Jason England, global bonds portfolio manager at Janus Henderson Investors. At the same time, the relative strength in stocks could allow the Fed to pursue even more aggressive rate hikes going forward.

"This will give the Fed more latitude to push harder on fighting inflation with rate hikes as the presumed Fed put was already at a lower strike price for this hiking cycle so with stocks rallying it gives them more room to go higher on Fed Funds rate," England said.