David Joy: Markets recharge after absorbing news from the Fed

Markets experienced a bout of arrhythmia last week after listening to Federal Reserve Chairman Bernanke’s congressional testimony, and then reading through the minutes of the Fed’s most recent Open Market Committee meeting. And the episode did result in the first weekly decline for stocks in the past five. But, the decline was relatively modest, at 1.1% in the S&P 500, and it moderated as the week came to a close. This is a rather benign response to what appeared to be a resetting of expectations as to when the Fed might begin to adjust the pace of QE3. In response to questioning, Bernanke said that the Fed could consider adjustments during the next few meetings of the FOMC, if the data is sufficiently strong. Yet, it is unlikely that will be the case, certainly not for long enough, for a policy adjustment to occur coming out of the June and July FOMC meetings. However, it does suggest that September/October is not too soon to be thinking about it, again if the data is strong. That is sooner than many investors had considered likely, and last week’s arrhythmia was the result. The fact that the selloff wasn’t more pronounced may be attributable to several factors. First, the Fed didn’t actually do anything. And even once it begins to make any adjustment, it will not go from 100 miles-per-hour to zero. It will more likely only slow down, while remaining still quite accommodative and simultaneously reserving the right to speed up again, if necessary. Second, as Bernanke stated quite clearly, a reduction in QE3 will depend on evidence of strong and sustainable economic activity. So, any tapering should be viewed as a vote of confidence in the U.S. economy. It is what is supposed to happen if things work according to plan. And third, there is a widespread belief, although by no means universal, that the U.S. and global economies will improve during the second half of the year. If so, then less Fed accommodation is to be expected and can be absorbed more easily. The market’s reaction to the Fed also extended to bonds. After closing at a yield of 1.93% on Tuesday, the ten-year Treasury note spiked to a yield of 2.04% on Wednesday, as the prospect of less Fed buying going forward took its toll. But just as with stocks, this adjustment did not turn into a rout, and by the end of the week the yield had settled modestly lower at 2.01%. The fallout in mortgage-backed securities was more pronounced. The yield on Fannie Mae 3.0%, 30-year bonds rose to its highest level in a year at 2.82% by the close on Friday, after ending the day last Tuesday at 2.66%. It is interesting to observe how these reactions are playing out this week, as trading gets underway after the long holiday weekend. Stocks were sharply higher in early trading on Tuesday, and bond yields were moving higher. Following gains in both Asia and Europe, U.S. equities were 1.3% higher just one hour into the trading day, and later resided above the record closing high of last Tuesday, the day before Bernanke spoke. And bond yields continue to move higher. The yield on the ten-year is higher by ten basis points at 2.11%, its highest in over a year. And mortgage bond yields are also higher, moving up to 2.91%. These moves suggest that the prevailing view is that economic activity is improving, and that stocks will benefit from rising revenues and earnings, despite the possible future tapering of QE3. And once again, it is the cyclical sectors that are pushing stocks higher, as they have since late April. The move in bonds suggests that the possibility of rising demand for credit and diminished buying by the Fed are pushing yields higher. Consistent with these trends, the dollar is stronger and energy prices are higher.Careful attention will be paid to see if markets extend these moves. As we have written in the past, the anticipation of firmer economic data is not the same as actually getting it. If it does materialize, that will be good news for stocks, but will of course get us closer to a change in Fed policy. Market reaction to its eventual implementation might not be as benign as what we are presently witnessing. The next important data point for Fed policy will come on June 7 with the report on May employment. The consensus is looking for the creation of 165,000 new non-farm jobs and a stable unemployment rate of 7.5%. This would not seem to ascend to the test of substantial improvement in the labor market that the Fed has established for itself. Even if the report turns out to be stronger, it seems highly unlikely that enough evidence will have been witnessed to satisfy the Fed by the time it next meets on June 18-19, nor by its July meeting for that matter. But it still leaves open the possibility of action by the September and October meetings.

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