Fed Interest Rate Hike Expectations Have Declined Sharply

Expectations Declining Image5/03/11: In the markets, as in life, there are no guarantees but everyone is entitled to their opinion. Here’s my opinion on the financial markets today.

The Nitty Gritty Details:

Stocks opened slightly lower this morning as further weakness in natural resource stocks and mixed earnings news from several key energy, healthcare and consumer product companies weighed on the broad averages.  Silver is under additional selling pressure this morning as higher margin requirements are driving away some speculators.  Meanwhile, crude oil is down about a dollar to near $112.50 on demand concerns after signs of slower manufacturing activity in the United States and China as well as some risk premium unwinding following bin Laden’s death.  The broad commodity indexes are roughly flat as gains in copper and several soft commodities are offsetting losses in crude, soybeans, and silver.  Weakness overseas is contributing to this morning’s bearish tone, with European stocks broadly lower and India’s stock market down over 2% after its central bank raised interest rates by 50 basis points.

Looking back at Monday, the early Bin Laden-driven rally faded.  Initial gains fizzled later in the day as weakness in Energy (-1.3%) was too much for the broad market to overcome.  The economic data had little influence on stock trading, including a slight dip in the ISM manufacturing index as expected and increase in construction spending for March, although the data may have contributed to some incremental weakness in commodity prices.  Healthcare (+1.0%) was the only sector to get much of a bid Monday as the market’s shift toward defensive sectors seen in April carried over into the first trading day of May.  The sector benefited from merger headlines and mostly better-than-expected earnings.  Commodities were mostly lower, led by a big drop in silver futures.  U.S. crude dipped 40 cents to near $113 a barrel.

Around our financial planning firm this morning, we were discussing four items that we thought would be of particular interest to our readers:

The Markets Broken Down:

  1. Fed rate hike expectations have really fallen off. According to Fed Fund futures, a first interest rate hike from the Fed is not fully priced in until the June 2012 FOMC meeting.  The trajectory of short-term rates is benign after that, with only a 2% Fed Funds rate priced in by the end of 2012.
  2. The end of QE2 may not have much impact on Treasury yields. Although the loss of $75 billion in Fed purchases will leave a void, other market participants, such as pensions, banks and households may be able to make up the gap if they resume prior buying habits.  Oddly enough, each of these entities sharply curtailed buying just as the Fed ramped up purchases in Q4.  We believe an increase in yields may be modest and believe that supply/demand dynamics play a secondary role to the primary drivers of bond yields: economic growth, inflation, and Fed interest rate changes.  With the Fed on hold for some time, economic growth and potential inflation consequences will be the primary driver of bond yields.
  3. Municipal bonds outperformed for another week. Low supply continues to provide a favorable backdrop for high-quality municipal bonds to outperform Treasuries for a second consecutive week.  Supply forecasts for May have been revised downwards suggesting the benign backdrop may continue.  Municipal bonds have increased the performance gap over Treasuries with a year-to-date gain of 2.3% following a 1.8% increase in March.  Due to the strength in Treasuries, however, municipal valuations are relatively unchanged and remain attractive compared to Treasuries.
  4. The Institute of Supply Management’s (ISM) Report on Business ticked down between March and April, and has probably peaked for the cycle. The ISM will likely drift back to 50 as it usually does a few years into a recovery.  All the leading components (new orders, backlog, new export orders) of the ISM look solid, and point to continued growth in the manufacturing sector in the quarters ahead.  A reading below 50 means the manufacturing sector is contracting.  A reading below 44 means the overall economy is contracting.  Employment in the manufacturing sector appears to have developed significant momentum, as the Employment Index components of the ISM in the first four months of 2011 are the highest readings since 1973.

As always, email me here with your questions or comments.  I love to hear from you and thoroughly enjoy the “intellectual debate” with our clients and friends that these opinions generate.

Greg Powell, CIMA
Wealth Consultant

Note: The opinions voiced in this material are for general information and are not intended to be specific advice. Any indices such as the S & P 500 can’t be invested into directly. Past performance is no assurance of a future result.

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