Should investors heed Yellen's warning?

For the last few years, Wall Street has been under the spell of the Federal Reserve. Buoyed by the central bank's bond-buying program, the S&P 500 large-cap index has gained more than 40 percent since 2012 while avoiding any sudden downdrafts.

But that seemingly unstoppable uptrend has hit a wall so far this year with stocks mired in a sideways trading range going back to November.

The reason? Growing concern that the Fed is set to raise short-term interest rates for the first time since 2004, effectively withdrawing the drip-line of easy money that capital markets have grown addicted to. And some economists warn that the Fed could tighten policy more aggressively than investors expect.

This week, a few wrinkles appeared in that outlook.

First, Fed Chair Janet Yellen raised more than a few eyebrows when on Tuesday she warned that equity market valuations are "quite high" and high-yield bonds may not be offering enough return -- referring to the "yield spread" over Treasury bonds -- to justify the risk. An analysis by Brad McMillan of Commonwealth Financial Network back in February illustrated that prices are indeed stretched.

If that wasn't enough, she also cautioned that when the Fed eventually moves to hike rates sometime later this year or early 2016, raising the cost of money for the first time since 2006, long-term interest rates could spike violently.

While Yellen has a reputation has a policy dove, she has actually been quite hawkish in the past: "The [Federal Open Market Committee] is determined to ensure that we never again repeat the experience of the late 1960s and 1970s, when the Federal Reserve did not respond forcefully enough to rising inflation and allowed longer-term inflation expectations to drift upward," she said in a speech in 2011.

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A second wrinkle is that the fixed-income market is already pushing up long-term interest rates -- front-running the Fed -- as inflation expectations start drifting higher. While recent economic data have been disappointing, including a very soft first-quarter GDP performance and some of the recent data points on jobs ahead of Friday's key payroll report, bond traders are apparently looking through this to a rebound in the second half of the year.

The big rebound in energy prices could be playing a role, with crude oil testing above $62.50 a barrel this week for the first time since December, a 47 percent increase from the March low. Gasoline futures are up nearly 60 percent from their January low. And while job gains have slowed, the labor market is tightening, with the unemployment rate at 5.5 percent and business surveys highlighting a dwindling pool of qualified applicants, precursors of wage inflation.

All of these factors -- higher inflation expectations, rising commodity prices, a tightening job market -- could cause price gains to quickly hit and pass the Fed's 2 percent annual target sooner than many anticipate. Yellen's hawkish side would be unleashed as the monetary punchbowl is pulled away for the first time in years.

The long-delayed 10 percent stock market correction would likely follow as higher interest rates undo many of the justifications for high equity valuations including debt-fueled corporate share buyback programs, for instance.

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Wall Street insiders aren't waiting around. Measures of market breadth, or the percentage of stocks moving to the upside, have fallen to levels not seen since early February as bulls bail out of a growing number of issues.

A strong payroll report this morning -- analysts are looking for 220,000 nonfarm payrolls and a drop in the unemployment rate to 5.4 percent -- could be a "good news is bad news" situation by feeding the dynamic outlined above. A weak report could also fuel volatility should bond market inflation expectations increase if traders believe a temporary jobs slowdown will cause the Fed to postpone rate hikes into 2016.

  • Anthony Mirhaydari

    Anthony Mirhaydari is founder of the Edge , an investment advisory newsletter, and Edge Pro, options newsletter. Previously, he was a markets columnist for MSN Money; a senior research analyst with Markman Capital Insight, a money management firm; and an analyst with Moss Adams focusing on the financial services industry.