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Stocks close modestly lower on interest rate fears

In many ways, the stock market is like the weather in that if you don’t like the current conditions all you have to do is wait a while. – Lou Simpson, former CEO of Geico and investment manager for Berkshire Hathaway

In what has become a discernible trend over the last several weeks, the stock market took its cue from the bond market and closed modestly lower as interest rates continued to rise. All three major stock averages declined as the yield on the 10-year Treasury rose to 1.73%, the highest level since January 2020, and the 30-year Treasury yield breached the 2.5% level for the first time since August 2019. For the most part, economic data released last week was weaker than expected, which should have caused interest rates to fall rather than rise. The Federal Open Market Committee (FOMC) also met last week and, as expected, left the federal funds rate unchanged near zero with continuation of its $120 billion monthly bond purchases. Although the Fed upgraded its economic outlook to include stronger growth and expects core inflation to increase to 2.4% this year, it sees no interest rate hikes through 2023 and will allow inflation to run hotter than usual to ensure a full economic recovery. Fed Chairman Jerome Powell said that “substantial further progress” would have to be made toward achieving its inflation and employment goals before it would consider tapering its monthly bond purchases. Fed officials believe that the unemployment rate will eventually drop to 4.5% from its current level of 6.2% as the economy gains strength. The Fed also emphasized that if inflation does get out of control, it has the tools necessary to control it. While investors took this news in stride on Wednesday, it was a different story the next two days has stocks sold off when the yield on the 10-year Treasury spiked as high as 1.76%. Most of the damage was in the technology-heavy Nasdaq Composite Index, but the Dow Jones Industrial Average and the S&P 500 Index also suffered losses. With the number of Covid-19 cases on the decline and more vaccinations on the way, rising inflation expectations along with rising interest rates have now become the biggest risk for the stock market.

Last Week

Retail sales in February dropped 3%, much worse than expected, but January retail sales were revised significantly higher. The decline was partly due to unseasonably cold weather across much of the country, but the drop should be temporary as the $1.9 trillion stimulus bill was signed into law that will send an additional $1,400 to most Americans. Housing starts in February plunged 10% to their lowest level since August due to the severe cold weather and leading economic indicators were up modestly and less than expected. Weekly jobless claims totaled 770,000, above the estimate of 700,000, despite sharply reduced restrictions due to the pandemic. The only positive piece of economic data last week was the Empire State Manufacturing Survey for March, which hit the highest level since last July and grew for the ninth straight month.

The Bank of Japan (BOJ) kept its benchmark interest rate unchanged at negative 0.1%.

For the week, the Dow Jones Industrial Average fell 0.5%% to close at 32,627 while the S&P 500 Index lost 0.8% to close at 3,913. The Nasdaq Composite Index also declined 0.8% to close at 13,215.

This Week

Both existing home sales and new home sales in February are expected to be slightly lower than the number reported in January. Durable goods orders for February are forecast to increase slightly but less than in January and the final reading for 4th quarter gross domestic product (GDP) is expected to match the second estimate of 4.1%.

The most prominent companies scheduled to report quarterly earnings this week are Adobe, GameStop, KB Home, Winnebago Industries, General Mills and Darden Restaurants.

Portfolio Strategy

The Federal Reserve will once again be in the spotlight this week as Fed Chairman Jerome Powell is scheduled to testify before the Senate and the House. If last week’s reaction to the Fed’s statement is any indication, both the stock and bond markets could be in for a volatile week. After its two-day meeting, interest rates spiked and stocks sold off as investors reacted to the fact that the Fed is willing to let inflation and the economy run hot in order for the job market to recover. The Fed issued a new growth forecast that calls for an increase in the gross domestic product (GDP) of 6.5% this year and an increase of 2.4% in the personal consumption expenditures (PCE) index for inflation, above its target of 2%. But the Fed also believes that this pickup in the inflation rate will just be temporary and that it will fall back to 2% next year. With the Fed on record saying that it won’t raise the federal funds rate until 2023, the markets are skeptical given the new projections for growth that would lead to higher inflation and presumably higher interest rates. The Fed’s preferred measure of inflation, the PCE index, will be released this week and it has been running at 1.5% through January, considerably below the Fed’s target. Ordinarily, strong economic growth, moderately higher inflation, improving earnings and easy monetary policy would be a perfect scenario for investors. However, higher bond yields and lower prices (bond yields move inversely to price) could result in more volatility while higher inflation could be problematic for both stocks and bonds over the near-term.

Since I will be out of the office the week of March 29th, the next Weekly Market Commentary will be sent on April 5th.