Janet and the Feds

Friday found the three major US stock market indicators having rebounded strongly from the week before. The S&P 500 closed within just 9 points of its all-time high, the NASDAQ closed at its highest value in 15 years and the 10 year US Treasury note dropped about 10 percent from its week prior return.

Just a week before, the latest end-of-the-market-world-as-we-know-it focus of the financial media was all about how much lower either the stock or oil markets would be going. Then, early this past week, seeming to add to the concerns, we saw the lowest US oil price since March, 2009 and gold hit its lowest point in the past four months.

Well, as I mentioned in last week’s letter, most of the market’s recent turmoil, including these drops in oil and other commodities, has been related to the strong dollar. According to CitiFX, the dollar’s rally over the past eight months had been its fastest in at least 40 years. A dollar having been made stronger by our strengthening economy, together with the global market’s perception that the US Federal Reserve Bank would soon announce that it was going to start raising interest rates.

While their markets are already starting to reflect the anticipated benefits of both the European Central Bank and the Bank of Japan’s easing programs, the economies in those areas are still weak. For instance, this past week, Sweden’s central bank, the Riksbank, cut its interest rates to minus 0.25%. This push and pull between US yields, driven by trader’s guessing what the Fed may do with our rates, and the near zero, plus or minus, of European and Japanese current yields has added to the daily volatility.

The stock market has not reacted generally well to the rising buck because traders seem to be afraid that the strong dollar will hurt the profits of multinationals by making their overseas revenues relatively less profitable; thus, causing a drop in earnings and share prices. In fact, there’s little history of the first rate hike in a tightening cycle ending a bull market.

What happened to cause the change? Janet and the Feds, of course.

What did they say?

In the official announcement on Wednesday of the minutes from their most recent meeting, the Federal Open Market Committee (FOMC) said this. “The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.” In addition to the two areas mentioned, the FOMC is watching “financial and international developments.”

For those of you not fluent in Fedspeak, my interpretation of this and other comments from the session is that first, they’re holding the Fed Funds target rate at 0-0.25%. As they decide their next move, members will be weighing how inflation, jobs, global growth and financial markets stack up with their long-term inflation and employment targets. The Bank isn’t locking itself into either a predetermined time or an increment for a rate raise. It’s becoming data dependent for that.

The Dot Plot, which is part of the FOMC’s Summary of Economic Projections, shows where each participant in the meeting thinks the Federal Funds rate should be at the end of the year for the next few years and in the longer run. It’s not an official policy tool. However, it provides us some insight into how the members feel about economic and monetary conditions going forward.

As of this meeting, the new median dot for the end of 2016 is at 1.875%, down from 2.5% in December. For 2017, the median FOMC member sees rates at 3.125%, down from 3.625% in December.

Markets interpreted this week’s Fed’s latest statements and economic forecasts to mean it’s going to raise rates more slowly than predicted. The market thinking has moved toward expecting the rate rise at the Fed’s September meeting, rather than in June as was the thinking before last Wednesday. In any case, the postponement caused the dollar to drop as US interest rates moved lower. This made stock values jump and boosted oil and gold prices, as well.

Why does it matter?

The reason is that short-term interest rates serve as the basic competition for investors’ money. Overly simplified, if rates rise high enough so I can earn a fixed rate of return on my investment that provides me a suitable rate of return for my needs, I may be less willing to invest in stocks. This could then cause the stock market to drop as money flows into fixed income issues or new money doesn’t even look at stocks.

This isn’t even a remote concern right now. The US 10 year Note is at 1.93%. I believe short-term rates would have to rise to 3.50% for this to be an issue. That’s like light years away in bond yields right today

While the rate rise is on hold for now, be prepared to experience another trip to market déjà vu as we move closer to the meeting where the market believes the Fed will actually make a rate rise announcement. Rates will rise in advance, as will the dollar. Understand that most of the market action around that event will be driven primarily by short-term trading, as has been the recent action.

Summary

The markets are always volatile in times of monetary transition. Don’t let short-term price flips make you too happy or sad – it’s the trends that are important. Our trends remain quite solid.

Let me offer a quote from economist Dr. Scott Grannis which is a fine summary for where we are now. He observed that, “The prevailing mood of the market-at least as I see it-which still exhibits a good deal of excess caution. Households have amassed almost $8 trillion in bank savings deposits, despite their miserably low yield. Nominal yields on high quality bonds are near record lows, and real yields on 5-yr TIPS are zero. The demand for safe, risk-free assets has never been stronger.” The wall of worry that prevails in bull markets seems to remain formidable…a good thing.

Let’s check the facts. Companies are sitting on huge cash reserves and profits are at record highs. The Index of Leading Economic Indicators continues to rise. Business loans are increasing. Employment continues to gain. What’s not to like?

Please let me know how I can help you get to where you want to be…

Cheers!

Mike

Securities and Investment Advisory Services offered through KMS Financial Services, Inc.

To get an overview of economic conditions, use this link. It’s updated monthly. http://www.russell.com/Helping-Advisors/Markets/EconomicIndicatorsDashboard.aspx

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