Markets Eke Out Gains Despite Rate Concerns

February 23rd, 2018

Markets struggled to build on last week’s rally as investors continued to focus on rising interest rates. Concerns over the Fed’s rate path drove the U.S. 10-year treasury yield to a 4-year high of 2.95%. The release of the Fed’s January minutes managed to unsettle traders even though the central bank reaffirmed its commitment to gradually hiking interest rates so as not to disrupt the economy’s momentum. Markets remain concerned over the Fed’s belief that inflation will reach the 2.00% target level in 2018, which could force the central bank to move more aggressively later this year. U.S. economic data was light this week with existing home sales posting an unexpected drop in January. In overseas news, the Eurozone manufacturing sector showed continued strength while inflationary pressures remained low. A late week surge helped push the Dow up 0.36% for the week.

Fed Minutes Signal More Rate Increases Ahead

Bond investors poured over the January Fed minutes for signs the Federal Reserve would move faster than anticipated to hike interest rates in order to head off rising inflation. Outright bearish sentiment was held at bay, however, by the Federal Reserve confirming, once again, that it would continue with its gradual rate hike path in response to strong economic growth despite the expectation that consumer prices would reach their 2.00% target level in the coming year. The meeting minutes were drafted, though, prior to last month’s jobs report which showed unexpected strength in average hourly earnings (+2.90% year-over-year), and it follows on the heels of a 0.50% monthly broad-based gain in prices from last week’s inflation report. As such, the Fed’s comments were not as calming as they otherwise might have been. The Fed will have another jobs and inflation report in hand when it meets next month, at which time we would expect another rate increase.

First-Time Homebuyers Sidelined

Existing home sales fell -3.20% in January (month-to-month) to a seasonally adjusted annual rate of 5.38 million units. This missed economist estimates for a 0.90% increase to 5.60 million units. Year-over-year, sales declined -4.80%, posting their biggest drop since August 2014. The drop in existing home sales was largely due to demand outstripping supply, with the tight inventory pushing up prices and lowering affordability for first-time buyers. House hunting prospects are likely to remain difficult looking ahead since supply is expected to remain tight and as mortgages rates move higher in conjunction with Fed interest rate hikes.

 

Eurozone Businesses Fired Up

It was another strong quarter for Eurozone manufacturing despite the IHS Markit Flash PMI Composite easing somewhat to 57.5 in February from 58.8 in January. Readings above 50 indicate expansion in the manufacturing sector while readings below 50 indicate contraction. Despite February’s slowdown, it was still one of the most expansionary, or farthest reading above 50, in more than 11 years. Business optimism remained near a 6-year high with expected output in a year’s time rising to 68.3 from 68.0. In short, the report showed that Europe is finally enjoying some sustained momentum in its manufacturing sector, which appears to be ramping up for a busy 2018.

Eurozone Inflation Below Target

Unlike the U.S., consumer prices in the Eurozone remained well below the European Central Bank’s 2.00% target. Prices rose 1.30% year-over-year in January, down from the 1.40% annual increase in December. Core prices, which exclude volatile food and energy prices increased 1.00%, up slightly from December’s 0.90% rate. The report indicates prices are still far below the central bank’s goal, despite the sustained economic backdrop, which should keep central bank policymakers from deviating too far from their ultraloose monetary stance.
 

Since this week was light on heavy-hitting economic news, investors’ main focus remained on the bond market and the impact of rising interest rates. A jump in interest rates corresponds to lower bond prices as investors sell longer and lower yielding bonds for shorter higher yielding bonds. Markets have been paying particularly close attention to the yield on the US 10-year Treasury as it inches closer to 3.00%. While 3.00% is an arbitrary level, if the treasury were to break that level it could lead to more reshuffling among investors simply from a technical or psychological standpoint. We’ve already seen yields on 5-10 year treasury bonds jump 0.50% so far this year, resulting in intermediate-term bonds losing roughly -3.00% to -4.00%. Assuming investors have heeded the Fed’s comments, this should mean that the market has priced in 2-3 hikes with a potential fourth in the wings. Should the Fed signal another increase or two, then one might reasonably expect another -2.00% or -3.00% downside from here. Not a disastrous move when you think about it relative to equity market movements, but we remain very defensively positioned to interest rate risk within our bond portfolio by holding mostly short-term and credit sensitive interests. The hope obviously being that either the yield curve flattens, in which case our short bonds will earn as much as longer durations, or there will be a larger, vertical shift in the curve that would make longer duration bonds attractive once again.

 

The Week Ahead

U.S. manufacturers provide their latest take on the state of the industry as the ISM Manufacturing report is released. We’ll also get the second estimate of U.S. Q4 2017 GDP. In China, the spotlight also shines on manufacturers as they report their latest figures.

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Sample for illustrative purposes only.

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