The Federal Reserve raised rates this month.
This was no surprise to the markets and continues the path the Fed has telegraphed.
While the Fed and the stock market are behaving in a manner consistent with a belief that the economy is strong and inflationary pressures are building, the longer-end of the bond market, the 10-year to 30-year part of the curve, is apparently singing a different tune.
Bond rates have gone down
Interest rates on the 10-year and 30-year Treasuries actually went down. Typically rates fall when the bond market expects an economic slowdown and low or falling inflation.
It’s possible that the bond market is concerned about the global saber-rattling over trade. Trade wars have been shown to reduce economic activity. Tariff barriers in the 1930s may not have started the Great Depression but research indicates that they certainly contributed to the global slump.
The stock market seems to be taking the tariff situation somewhat in stride, trading in a relatively narrow range. Perhaps the stock market believes that the probability that trade issues ultimately get resolved is higher than the probability that a trade war develops.
More important than the trade talk bluster, the European Central Bank outlined a timetable for tapering its quantitative easing program. The ECB stated that starting in September, it intends to reduce bond purchases and stop altogether by December.
This news was largely overshadowed by trade talk. I believe that US rates long-term interest rates have been kept low, in part, by European investors buying US paper to get higher yields than what they can get at home. If Europe begins to “normalize” their rate structure, money should flow out of US bonds and into European bonds.
Higher interest rates and positive fundamentals tug of war
Under this scenario, long-term rates in the US should go up. I think we will re-visit the tug of war between higher interest rates and positive fundamentals for stocks that we experienced earlier in the year.
That is to say that higher rates hurt asset valuations but a strong economy, solid corporate profits, increased buybacks, and higher dividends help stock prices.
Stock market watchers should note that while the S&P500 seems to be treading water, the small-caps have been moving up. The cumulative number of stocks advancing has been greater than the cumulative number of decliners. Companies are using the tax savings from the new code to yes, spend more on capital goods, but mostly to increase dividends and buy-in shares.
We will get a better picture of company profits as firms report their 2nd quarter numbers in a few weeks. Estimates are calling for a 19% quarterly year-over-year increase in S&P500 earnings. That’s pretty good.
If the numbers come in, the market should be ok. So far, the evidence still supports The Bulls. However, keep an eye on trade. The bond market is.
— Ian Green, Pendragon Capital Management
Note: This blog article is intended for general informational purposes only. Nothing in it should be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product.