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Stocks relinquish gains after Fed rate hike

Maybe Christmas, he thought, doesn’t come from a store. Maybe Christmas…perhaps…means a little bit more. – Dr. Seuss from How the Grinch Stole Christmas

What looked like an auspicious start to the week for stocks ended in a sea of red ink as the market Stgave back its gains to close slightly lower in volatile trading. After the Federal Open Market Committee (FOMC) raised the federal funds rate by 25 basis points on Wednesday, the S&P 500 Index surged 1.5% on dovish language in the Fed statement and favorable comments by Fed Chair Janet Yellen. With the increase, the target range for the federal funds rate has now been raised to 0.25% to 0.50%. Investors cheered as the uncertainty over an initial Fed rate hike had been eliminated and the Fed’s action sent a message that the economy was strong enough to withstand an increase in rates. The decision was unanimous among the committee members as they cited considerable improvement in the labor market and confidence that the inflation rate would reach their 2% target in the foreseeable future. But the euphoria was short-lived as stocks relinquished the gains on Thursday and tumbled again on Friday. While Janet Yellen made it clear in her press conference that the pace of any further rate hikes would be gradual and dependent on incoming economic data, investors remained skeptical. They questioned the Fed’s projection of four interest rate hikes in 2016, believing that the U.S. economy is not strong enough to warrant that many hikes. After last week’s mixed economic data and weakness in commodities, they could be right. The price of oil sank to below $35 a barrel and commodity prices in general were lower, which raised fears that global growth was slowing. Manufacturing data was also weaker than expected and the continued strength of the dollar only hurts profits of multi-national companies that sell their products overseas. With only two holiday-shortened weeks left in the year, tax-loss selling and low trading volume may only add to the recent volatility.

Last Week

The rate hike by the Federal Reserve was the first such increase in nine years and the 10-year Treasury yield actually fell to 2.20% as prices rose on strong investor demand for government securities. Lack of inflation may have been partly responsible for the drop in the yield. The consumer price index (CPI) for November was unchanged and the core CPI that excludes food and energy rose only 0.2%. In the 12 months through November, the core CPI has risen 2%. Industrial production also fell slightly in November.

The one bright spot last week was in the housing sector as housing starts rose over 10% in November and housing permits reached their highest level in five months. Both numbers signal solid housing activity ahead and bode well for the future.

For the week, the Dow Jones Industrial Average dropped 0.8% to close at 17,128 while the S&P 500 Index declined 0.3% to close at 2,005. The Nasdaq Composite Index fell 0.2% to close at 4,923.

This Week

U.S. gross domestic product (GDP) for the third quarter is expected to be revised lower to 2.0% from the previous estimate of 2.1% and durable goods orders for November are expected to drop slightly after posting a healthy increase in October. The Energy Information Administration (EIA) will also release an update on oil inventories, which could have an impact on the price of crude oil. Oil has dropped for the third consecutive week and is now at a 52-week low.

U.S. stock markets close early on Christmas Eve and will be closed on Christmas Day. In a very light week for quarterly earnings reports, Cintas, Nike Inc., ConAgra Foods and Micron Technology will be among the most notable companies on the calendar.

Portfolio Strategy

The reaction of the bond market last week to the quarter-point increase in the federal funds rate was a surprise and could portend more of the same. The conventional wisdom was that a Federal Reserve rate hike and the beginning of the tightening process would cause bond yields to rise. But by the end of the week, just the opposite had happened. The yield on the 10-year Treasury reached a high of 2.33% on the day of the Fed rate increase but fell to 2.20% by the end of the week. Even the yield on the two-year Treasury, which tends to move in lockstep with the fed funds rate, dropped from Wednesday to Friday. While the Federal Reserve seems confident that the economy is strong enough to justify a rate hike, the bond market seems to be marching to the beat of a different drummer. GDP growth in the third quarter was only about 2% and will be only slightly higher than that for the full year. With the Fed’s preferred inflation gauge running below its target of 2% and weak economies overseas in Europe and Japan coupled with slowing growth in China, the timing of an interest rate hike is questionable. The primary basis for the rate increase has been the strong labor market with its ongoing, outsized job gains and declining unemployment. But the labor participation rate has been near historic lows and it could be possible that employment growth has peaked. If this is the case, it may be a long time before the Federal Reserve raises interest rates again.