Equity Update – Domestic Stock Market Overview

Equity indices had their longest streak of record closes since January 1987 as positive sentiment swept the markets, propelling the major equity indices to new highs. The S&P 500’s market capitalization attained $20 trillion for the first time ever, a dramatic increase over the past few months.

The Dow Jones Industrial Average reached 21,000, its second milestone in less than 30 days after reaching 20,000. It took the Dow only 24 trading days to elevate from 20,000 to 21,000, tying a record set in 1999 for the shortest period between 1000 point milestones. Albeit, the Dow was at a much smaller level in 1999, making that move much larger on a percentage basis.

Market pundits believe that we have officially been in a bull market cycle for the past eight years, as major equity indices have continued to hit new highs since 2008. Many analysts and economists are linking the market’s eight-year run to the Fed’s monetary easing program, producing ultra low rates and yield seekers.

Bank sector stocks elevated as the expectation that Dodd-Frank regulations would be alleviated as well the Fed positioning for a rate hike fairly soon. Banks tend to perform better with less regulation and a higher interest rate environment.

Sources: Dow Jones, S&P, Reuters

Fixed Income Update – Interest Rate Overview

The 10-year Treasury yield fell to levels not seen since November 2016 when markets were still pensive about the outcome of the presidential election. The retreat of Treasury bond yields may signal that the strong asset flows into equities may be easing up.

Comments by Federal Reserve members in February signaled a solidifying stance for a rate hike as soon as March. Fed member William Dudley cited “sturdy job gains, increase in inflation, and rising optimism among business owners” as viable reasons for higher rates.

Bond yields stopped rising in February and reversed course as lower yields became the norm. Equity investors hesitated at the end of February and reallocated some assets to bonds, driving fixed income prices higher.

Sources: Bloomberg, Federal Reserve

Watch Reserves, Not Rates

As Washington DC melts down, entrepreneurs keep moving, people keep working and spending; the economy keeps growing.  The Federal Reserve keeps meeting and speaking, too, but now it appears they will actually act.

Next week’s Fed meeting (March 15th) is going to be major news one way or another.  Most analysts lean our way and now think the Fed will raise short-term interest rates by a quarter percentage point (25 basis points).  If the Fed does raise rates, it will be just the third rate hike in over a decade, but the second since December, signaling new urgency to normalize.

However, if the Fed surprises and declines to raise rates, despite all the hints from recent Fed speakers including Fed Chief Yellen herself, it will also be major news, suggesting the Fed has an unfortunate bias against raising rates under pretty much any reasonable conditions.  We don’t think that’s likely, but it would be big news.

Either way, investors need to focus on more than just interest rates.  Rate hikes under the current monetary regime are different than any other time in history.  In the past, when the Fed wanted the federal funds rate higher, it would shrink the amount of reserves in the banking system by selling bonds to banks and subtracting cash.  With a smaller supply of reserves, banks would bid up their cost.

But these days, there are roughly $2 trillion in excess reserves and the Fed has no plans in motion to reduce them.  As a result, a rate hike next week would push what the Fed pays banks on those excess reserves to 1% from 0.75%.  The idea is that if the Fed pays higher rates, banks will continue to hold reserves and money supply growth and inflation can be contained.

This experiment has never been tried before and no one knows if it will work.  In fact, there is good reason to believe it won’t.  An upward sloping yield curve suggests banks have more incentive to loan as rates rise, not less.

In other words, we will be watching the Fed’s statement for two things.  First, how quickly we can expect interest rates to rise in the year ahead, but also whether there are any plans to shrink the size of the balance sheet.

Don’t blink.  Things are changing rapidly.  Just nine weeks ago, the market consensus was a 31% chance of a mid-March rate hike and only two hikes for the year.  At Friday’s close, the March rate hike odds were 94% and that would be the first of three rate hikes in 2017.

As these expectations changed, 10-year rates have barely budged, closing Friday at 2.49% versus 2.45% at the end of December.  One possible reason for such a small change in the yield is that as long as investors think the cycle peak for short-term rates hasn’t changed, then the average short-term rate over the next ten years hasn’t changed much during the past few months.  So there was no reason for long-term yields to change much, either.

The problem with this theory is that equities are moving like investors expect faster economic growth than the Plow Horse pace since mid-2009.  In a faster growth environment, the peak for short-term rates should be higher, too.

We think bond investors will eventually come to this conclusion as well.  With nominal GDP growing near 3 ½% in the past year and likely to accelerate, the level of interest rates should rise toward that level as well.