With the Phillips Curve-obsessed Fed now widely perceived to be close to terminating its year-long rate-hiking exercise, the market is anticipating tomorrow’s employment report with a fervency out of all proportion to the data’s real-world significance. While another weak report would add considerably to the case against further action, the market must remain alert to the risk that a stronger-than-consensus reading will again give the upper hand to the FOMC faction centered around Governor Lawrence Meyer. Meyer has served notice that he will not rest until he sees evidence that unemployment is heading above 5%, from current levels around 4%, to head off the imagined threat of a wage-price spiral. As the Fed figure with the most at stake in keeping the Fed in tightening mode, Meyer is positively itching to cast aside last month’s reported contraction in private sector payrolls as a fluke. Thus is the long bond hovering at yields just below 5.9% after rallying from around 6% little more than a week ago.

At these levels, though, the upside potential of policy moving to a neutral stance appears to significantly outweigh the downside implications of any realistic scenario for further Fed action.  Standard calculations would suggest there is nothing particularly compelling about the real value in current yields. Based on a 12-month rate of change in CPI of about 3%, real rates are currently running at just less than 3%, actually somewhat below long-term averages around 3.5%. But the CPI, as well as other broad official price indexes, has been skewed substantially higher by the crude oil price surge since early last year. A more accurate depiction of underlying price trends is provided by the core personal consumption expenditures deflator, which is running at 1.8% year-over-year. Even this measure, however, is likely overstated.  Given the sustained strength in dollar purchasing power indicated by the price of gold remaining stable in ranges below $290 per ounce, as well as the currency’s continued vigor against foreign exchange, the price level is probably rising at a rate of no more than 1%. Long-term bond buyers must account not only for current inflation, but expected inflation over the life of the bond, plus the risk of unexpected future inflation. Still, current nominal yields can be seen incorporating a real-yield premium of at least 80-100 basis points in the present expectations environment.

Granted, further significant movement toward the 5% plateau isn’t likely until the market has some assuredness that the Fed is sidelined. By later in the year, though, bonds could well be garnering support, rather than facing resistance, from speculation over the Fed’s intentions. The unimpressive response of equities to the recent whittling away of rate-hike expectations suggests that the central bank may have already exceeded its stated objective of slowing the economy to a “sustainable” pace of 3-3.5% real expansion. If by year-end the economy appears to be braking to a 1.5-2.5% growth track, the betting will turn to chances that the Fed will soon be cutting rates, as opposed to raising them.