The major stock market averages gapped up at the open, but quickly faded. The Dow is currently flat and the SPX is up .25%. The Nasdaq is up .7%. The financial sector is down nearly 1% despite the Federal Reserve’s rate hike yesterday (see below). That’s quite a surprise. Utilities, telecom and real estate sectors, on the other hand, are up about 1% in early trading despite better economic data. European stock markets are surging today after the European Central Bank’s policy meeting (see below). The dollar is stronger today against a basket of foreign currencies and not surprisingly, commodities are mostly trading lower. WTI crude oil is down modestly to $66.50/barrel. Bonds are trading up modestly. The 5-year Treasury yield is pretty much unchanged at 2.82% but the 10-year Treasury yield ticked down to 2.95%. So the yield curve is flatter today. This is not at all what I expected to see this morning. What we have today is a tug-of-war between various powerful forces in the market. CNBC’s Rick Santelli characterized this market action as “incongruent.”
Yesterday, the Federal Reserve hiked its short-term policy interest rate by .25% to 2.0%. What that means is that most loans—autos, credit cards, mortgages—are .25% more expensive than they were yesterday. While the move was widely expected, investors weren’t really prepared to receive the accompanying statement. The investment community is used to parsing very minute changes in language from one statement to the next. But this time, new Fed Chair Powell cut it down to 350 words and drastically changed the message. The Fed is clearly more positive on the economy (“rising at the solid rate”), unemployment (“declined”), and consumer spending (“has picked up”). Therefore, the it now says two more interest rate hikes are appropriate this year. That means just about every lending rate will be .75% higher at the end of the year than it was yesterday. In addition, more “gradual increases” in rates will likely be needed next year.
The takeaways are 1) the economy is improving, 2) inflation will likely accelerate, and 3) rates will continue to rising, perhaps at a quicker pace. Is the Fed too aggressive? Will they push rates too quickly and choke off economic growth? Or are they correct in their assessment that economic growth and rising inflation necessitate higher interest rates? Thus far, they’ve been fair in their analysis of economic data and also very patient with monetary tightening, not willing to be responsible for killing the economic recovery and bull market in stocks. But yesterday, investors acted as if Mr. Powell has viciously turned on them. Wall Street strategists differ on the likely impact of more rate hikes. The CEO of Principal Investors said today he worries that a fourth rate hike at the end of 2018 could end up inverting the yield and leading to an economic slowdown. Famed bond fund manager Bill Gross, however, says despite the announcement, the Fed probably won’t end up hiking more than one more time this year. David Kelly of JP Morgan says rate hikes are an encouraging sign that the economy is strong, and anyway the Fed needs to get rates “back to neutral pretty fast” so the economy doesn’t overheat.
The European Central Bank (ECB) also concluded a policy meeting and said the Eurozone economy is strong enough to begin pulling back on monetary stimulus. This is somewhat surprising since Europe has lost some economic momentum lately, and Italy’s sketchy finances are back in the news. But ECB President Mario Draghi said economic weakness is temporary and GDP for the next couple of years should be around 2%. Therefore, the ECB will likely end its quantitative easing (or bond-buying) program at the end of 2018. It promised, however, to keep interest rates unchanged at current—very low—levels until at least the summer of 2019. The main takeaway is that with less stimulus, interest rates will be rising in Europe.
US retail sales surged in May, giving economists more confidence in consumers’ willingness to spend. Sales accelerated to 5.9% year-over-year growth, which is at the high end of the range over the past 6 years. In addition, The US Bureau of the Census upwardly revised April retail sales. Categories experiencing strong demand include restaurants, autos, department stores and gasoline. This report backs the Fed’s view that the economy is clearly improving.