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All Eyes on the Fed, Inflation, and the 10-year Treasury Yield

March 22, 2021
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Monday Morning QB - Market Observations:

  • Fed Chairman Powell Reiterates “Lower for Longer” is still the Correct Interest Rate Policy – Declares Low Interest Rates will Continue Through 2023
  • Fed Will Continue Buying Minimum of $120 Billion a Month of Treasury Bonds and Mortgage-backed Securities
  • The Federal Reserve Raises Their U.S. Growth Forecast
  • 10-Year Treasury Yields Climb above 1.7%
  • Weekly Jobless Claims Rise Slightly…Four Week Average Still Near Pandemic Lows
  • Hot Energy Sector Takes a Breather as Crude Oil Drops 5%

Monday Morning QB - Market Performance:

The jittery stock market continues.

On Wednesday, Fed Chairman Powell appeared to calm the inflation and yield concerns only for the worry to return for the remainder of the week.

The Dow Jones Industrial Average shed 150 points finishing the week at 32,627—a decline of -0.5%. The technology-heavy NASDAQ Composite declined a slightly steeper -0.8%.

By market cap, the large cap S&P 500 retreated -0.8%, while the S&P 400 mid cap index and Russell 2000 small cap index declined -1.2% and -2.8%, respectively.

What Happens When Forecasts and Data Do not Align?

The stock and bond markets both continue to look for clarity.

While hoping the Federal Reserve would provide answers last week, more questions may be raised. The markets are looking for balance between what the current economic data is showing and what many economists and investors are forecasting, i.e., hoping for.

Fed Chairman Powell continues to push the narrative that the federal reserve will continue to provide the economy the support it needs for as long as it takes. “As long as it takes” refers to a fully-recovered U.S. economy, which the Fed defines as sustainable 2% inflation along with a fully employed workforce.

The Federal Reserve is stuck between what is currently happening and where they hope the economy goes by the end of the year. The current data shows improvement but inflation is running below 2% and the unemployment data is improving but we are a long way off from full employment.

The forecasts are all looking for an economic boom.

Corporations are raising guidance on future earnings, raising both the projections for profits and sales revenue. Should the projections be realized in upcoming quarters, we will likely see positive earnings surprises. Positive earnings, including surprise earnings beats and better than expected reports, typically move the stock market higher.

The Federal Reserve is not blind to these company expectations.

Viewing the economy from a macro level, the Fed itself raised their forecast for the economy. The Fed raised their year over year growth forecasts for the U.S. economy to 6.5% growth in 2021.

Should this GDP forecast materialize, this will be the fastest expansion for the U.S. economy since the early 1980s.

So What is the Problem? Why is the Stock Market not Hitting New Highs Every Week?

I guess we just always need something to worry about.

What if the economy runs too hot? The Federal Reserve will need to abandon their current program of easy monetary policy too soon and raise interest rates to slow down our booming economy.

Because, it is believed, if they do not raise rates, the surge in consumer spending expected from the stimulus checks will be met by businesses without enough products to sell to the rabid consumer. Prices will skyrocket as too many people chase too few goods.

Inflation will blow through the 2% Fed goal leaving the Fed no choice but to increase rates and curb the U.S. economy in the process. The stock market will crash on the thought of companies cutting production to meet declining demand from a slowing economy, potentially ending in a recession.

Although there currently is nothing in the data that would suggest this scenario, investors worry none the less.

Chairman Powell’s retort: “Part of that is wanting to see the actual data rather than just a forecast at this point.” At this time, there are simply to many “what ifs” in the recession scenario.

Bring on the Party

All of us can not wait for the growth forecast to materialize. What a great problem to have – too much growth. Bring it on.

Fed Chairman Powell has already cited that a spike in the 10-year Treasury yield along with rapid inflation is likely temporary and he would look to be patient before determining if rates should be increased.

Why just temporary?  The “sugar high” from the full reopening of our economy combined with stimulus checks to spend cannot last long term.

So, get out there and do your part.

Get the vaccine, deposit your stimulus check (if you are getting a check), and get to spending. Let us overheat the economy. My guess? That scenario is rather good for your stock portfolio.

The Deficit Hawks

The other side of the issue is, of course, runaway inflation due to the rising deficits from government spending and the trade deficit from importing more than we are exporting.

The Federal Reserve has helped cover the deficit by printing money – buying U.S. government bonds.

The receipts from collecting taxes from the American Taxpayer do not cover our current amount of government spending.

The Treasury department sells government Treasury bonds to raise money to cover the shortfall from tax revenue. The Federal Reserve then buys the bonds issued by the Treasury, effectively monetizing the debt. (Debt monetization occurs when a country’s central bank prints money to fund current government spending.)

The big issue in running simultaneous trade deficits and government spending deficits is a weak economy and a weak currency.

From an economics standpoint all this makes perfect sense.

The problem is quantifying the effect of being the world’s currency. If most “things” are priced in dollars or pegged to the value of dollar it gives the U.S. a huge advantage. There is a greater demand for U.S. Treasury’s over other government debt.

As mentioned last week in the MMQB, Japan and the EU currently are experiencing negative interest rates to buy their respective 10-year government bonds.

Strong Treasury auctions help us easily fund our current deficit. The U.S. debt is financed cheaply in this low interest rate environment. The percentage of GDP needed to pay the interest on the debt is currently quite low in relative terms.

The "too much debt" argument has been around since the Great Recession and to date appears to sound like the boy who cried wolf.

Worrying about what may or may not happen drives me crazy. The second week of April cannot get here fast enough.

Earnings season starts again, and the silliness of speculation will give way to company data (facts), once again.

The changing of the guard from growth to value and from large stocks to small stocks continues.

Dips appear to be buying opportunities with the economic growth story still intact, especially entering the typically strong month of April.

Have questions, do not hesitate to call. Have a great week everyone!

(sources: all index return data from Yahoo Finance; Reuters, Barron’s, Wall St Journal, Bloomberg.com, ft.com, guggenheimpartners.com, zerohedge.com, ritholtz.com, markit.com, financialpost.com, Eurostat, Statistics Canada, Yahoo! Finance, www.stocksandnews.com, www.chaikinanalytics.com Chaikin Analytics, www.marketwatch.com, www.BBC.com, www.361capital.com, www.pensionpartners.com, www.cnbc.com, www.FactSet.com, W E Sherman & Co, LLC)
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