Stocks decline on interest rate fears

Derivatives are financial weapons of mass destruction. – Warren Buffett

The stock market succumbed to the laws of gravity last week as the S&P 500 Index declined about 1% after posting gains for five consecutive weeks. Although the calendar was light for both economic data and quarterly earnings reports, heightened investor fears over the possibility of higher interest rates caused the yield on the 10-year Treasury to jump to 2.61% after reaching 2.35% just several weeks ago. The main reasons for this unexpected spike in the benchmark yield were strong August retail sales and better than expected consumer sentiment numbers, both of which confirmed a strengthening U.S. economy. While this scenario should be interpreted as good news, it means that the Federal Reserve is more likely to raise interest rates sooner rather than later, a situation that causes fixed income investors to shudder because when yields rise, bond prices fall. Higher rates are also perceived as being bad for stocks since corporate borrowing costs rise, decreasing the level of earnings. Higher yielding fixed income investments provide competition for equities, too, but with far less risk and volatility. The fact that the Federal Reserve’s bond-buying program ends next month only contributes to investor anxiety over higher rates as the program was specifically designed to suppress interest rates. Though investors should be overjoyed with improving economic growth, any exuberance must be tempered somewhat by the real possibility of higher interest rates and the consequences that they may bring.

Last Week

A quiet week on the economic and earnings calendar came to an end on Friday as August retail sales rose 0.6% and the previous two months data were revised higher. Core retail sales that exclude automobiles, gasoline, building materials and food services were also up a robust 0.4%. In addition to the positive retail sales number, the September consumer sentiment index jumped to its highest level in a year. Jobless claims increased by 11,000 but are still near the low levels seen before the recession. The claims number also could have been distorted by the Labor Day holiday.

Global tensions will undoubtedly increase as the U.S. authorized air strikes in Syria and increased bombing in Iraq in order to degrade and ultimately destroy the Islamic State. The European Union and the U.S. also imposed additional economic sanctions on Russia to punish the country for its aggression toward Ukraine. Ongoing geopolitical risks could act to help keep a lid on interest rates as investors seek a safe haven in the form of U.S. Treasury securities.

For the week, the Dow Jones Industrial Average lost 0.9% to close at 16,987 while the S&P 500 Index shed 1.1% to close at 1,985. The Nasdaq Composite Index edged down 0.3% to close at 4,567.

This Week

Both the August producer price index (PPI) and consumer price index (CPI) are expected to show that inflation remains benign. Housing starts for August should register another healthy increase and provide further evidence that the housing recovery is back on track. August leading economic indicators should also confirm that the U.S. economy continues to strengthen.

The Federal Reserve Open Market Committee (FOMC) meeting is this week and all eyes will be focused on Fed Chair Janet Yellen to see if there is any change with regard to monetary policy and the timetable for raising interest rates.

The corporate earnings calendar is relatively sparse as prominent companies scheduled to report include Adobe Systems, Oracle, General Mills, ConAgra Foods and FedEx.

Portfolio Strategy

As the FOMC meeting draws closer, investors have become more worried about the Fed’s newest policy statement and their updated projections on the economy and interest rates. This anxiety was clearly evident last week as the 10-year Treasury yield rose sharply to over 2.6%, a rise of almost 30 basis points since late August. Past statements have been intentionally vague with regard to the timing of any interest rate hikes with language such as “considerable time” and “dependent on economic data” used to refer to the period between the end of the bond-buying program in October and the first rate increase. It is widely expected that this first rate hike will be in mid-2015.  It is safe to assume that no specific date will be used in the Fed’s policy statement. The Federal Reserve learned their lesson back in May 2013 when they hinted at a timetable for ending quantitative easing and saw the bond market plummet. While the wording that the Fed uses may indeed change, Fed Chair Janet Yellen will likely strike a dovish tone and reassure investors that there has been no change in their overall policy. Although the economy is definitely strengthening, the Fed does not want to make the mistake of hiking rates too soon and sending the economy back into a recession. With geopolitical risks not going away and European countries struggling to grow their economies, any rise in interest rates should be gradual. If this scenario plays out, an improving economy should provide the backdrop for a higher stock market.