Word comes down from Constitution Avenue today on how long the Fed thinks these zero rates might last.
It won’t be in the form of any promises, obviously, but the Fed’s “dot plot” of future rates might get a closer look than normal from investors veering between excitement over reopening and fear of overheating. Last December’s dot-plot showed only one Fed official predicting a rate hike next year and five seeing one in 2023. The question is, will today’s report show more hawkishness?
Leading up to the end of the meeting, trading this morning might be a “rinse and repeat” of what we saw yesterday, with everyone waiting around for the Fed. It seems unlikely that Fed Chairman Jerome Powell will say anything that much different, but this meeting has more meaning than most because we’re on the verge of the vaccine taking hold and the economy picking up. There could be a lot of change before the Fed’s next meeting in late April.
No one, not even Fed governors, knows for sure where rates might be a year or two from now. That being said, today offers the first road map of their extended thinking since December, a time when the 10-year Treasury yield was near record lows at around 0.9%. Since then, it’s stormed its way up to above 1.6%, the highest in more than a year. By this morning, it reached 1.67%, and this gets back to the recent economic numbers looking pretty good.
It’s Not Price, it’s Pace
Even a yield of 1.67% is still very low, historically, but it’s the speed of the rally that has some investors worried. Not that you’d know, because stocks are still flirting with record highs. However, the 10% recent correction suffered by the Nasdaq 100 tells you where the market might feel some pain if yields continue climbing. Growth stocks, including Tech, tend to take it on the chin when yields rise, because they’re highly valued based on hopes for strong future growth. Climbing yields could get in the way of that, and the market’s focus right now is on 2%. A rally to that level would almost certainly cause some soul searching, so to speak.
Another thing people could watch for is the Fed’s outlook on economic growth and inflation, and anything Powell or the Fed’s statement says about future bond-buying plans. The Fed’s been steadfast saying it has no changes in store for the $120 billion a month purchases intended to put a brake on rates. However, with Goldman Sachs (NYSE:GS) recently predicting 8% U.S. economic growth this year, some analysts wonder if the Fed needs to be greasing the skids quite this much, and whether it might risk overheating by doing that.
One question on some minds is whether the Fed might decide to do a “twist” and buy longer-term bonds instead of shorter-term ones. The 30-year recently traded at a 14-month high near 2.4% and mortgage rates climbed above 3%. Housing has been a shining star for the economy and the Fed probably doesn’t want to let that get snuffed out. Meanwhile, media reports say companies are rushing to borrow before yields get too high.
Powell, who holds a press conference soon after the meeting ends at 2 p.m. ET, is probably going to do his best not to upset any apple carts. In recent appearances, he’s stressed that the economy still has a long way to go toward recovering from the pandemic, and that unemployment remains too high. He’s said that the Fed is willing to let inflation run above its 2% target if that helps get the economy back to full employment, and if inflation gets tricky the Fed has ways to handle that.
Besides the Fed: Nike, FedEx and China Talks
Tomorrow afternoon, FedEx (NYSE:FDX) reports its quarterly results, which are often considered to be a proxy for economic activity. Those results come into sharper focus after the disappointing February retail sales number released yesterday. We also expect to hear from Nike (NYSE:NKE), whose earnings are often a good barometer of how Chinese consumer demand is doing.
Speaking of China, we talked yesterday about this week’s discussions between the U.S. and China, which might include trade as a subject.
The real question is whether the two countries can expand their conversation beyond agriculture, where trade is already booming. That may be in the works. The U.S. and China are setting up a semiconductor working group to ease tension in industry and improve supply chain security, the Hong Kong-based South China Post reported late last week.
The paper added that there’s speculation the Biden administration could relax certain trade restrictions against Chinese semiconductor companies to help ease a global shortage of chips, a move that could help Chinese firms. That remains to be seen, but keep an eye on the Philadelphia Semiconductor Index, which fell into correction this month. Any progress on China trade might give it a boost.
One For You, 19 For Me?
A potential source of pressure ahead might be investors grappling with something they haven’t had to very much over the last 25 years: The possibility of rising federal taxes.
Bloomberg reported that the Biden administration is considering a package that would reportedly include: Raising the corporate tax from 21% to 28%; increasing the income tax rate on people making more than $400,000; expanding the estate tax; paring back tax preferences on pass-through businesses such as limited-liability companies; and setting up a higher capital gains tax rate for individuals making at least $1 million.
Just a few years ago, Congress delivered one of the biggest tax cuts in history, so this is kind of a 180. If tax discussion gets to be more front and center in the weeks and months ahead, you could see it take a little wind out of the market’s sails (see more below).
Maybe think of Tuesday as a dress rehearsal for today. Major indices chopped up and they chopped down, trading “both sides of unchanged,” as traders in the open outcry pits used to say. Eventually things finished mixed. The NASDAQ Composite managed to finish slightly higher but other indices dragged after a very firm Monday.
It was the second week in a row that things went in reverse from Monday to Tuesday. More choppiness is likely today until the Fed meeting. Key data comes tomorrow with weekly initial jobless claims. Analysts expect 710,000, down from 712,000 a week ago, Briefing.com said.
One feature yesterday worth watching for today was profit taking in a lot of the same travel-related stocks (airlines and cruise lines) that had popped higher Monday. Some of this might have hinged on news of new virus case surges in Europe where vaccine availability is an issue.
As reopening stocks faded, the quarantine/stay at home ones continued to look strong. Semiconductors, for instance, have had a very nice start to the week. They could be getting help from news that several major automobile companies cited chip shortages getting in the way of their production. A shortage would probably raise chip prices, helping their makers.
Also, all the so-called “FAANG” stocks are coming back nicely from recent weakness. Apple (NASDAQ:AAPL) and Facebook (NASDAQ:FB) were leaders in that category yesterday. As we’ve seen often in the last few years, Tech stocks do go down, but haven’t stayed down for long. We’ll see if that continues to be the case after the most recent market correction in that sector. So far in pre-market trading Wednesday, the tech-heavy COMP was under more pressure than other major indices, but trading is likely to be thin across the market this morning as traders wait for the Fed.
Rising yields had weighed on Tech and could continue to hinder progress in the rest of the stock market, depending on what the Fed says today. Meanwhile, volatility really has pulled back. The Cboe Volatility Index (VIX) closed below 20 for the first time since Feb. 21, 2020. Again, we’ll see if anything changes as Powell talks.
Crude is down this morning after the International Energy Agency (IEA) called a “supercycle” for the commodity unlikely in its latest forecasts, MarketWatch reported. Oil inventories still look “ample,” IEA said.
VIX Daily Chart.
CHART OF THE DAY: SUB-20 VIX—WE’VE MISSED YOU. Most of us have a list of things we haven’t done or seen in over a year—concerts, conferences, and weddings, to name a few. Here’s one we’ve been living without, until yesterday that is: A close below 20 in the Cboe Volatility Index (VIX). It was Sunday night, February 23 of last year, when the pandemic began to pound the futures markets. The fear gauge raced past 20 on its way to a high above 80 within the next month. The VIX dipped below 20 (blue line) a couple times in the past year, but each time, fear re-entered the scene almost immediately. Have we turned a corner this time? Tough to say, but the VIX is starting Wednesday back above the 20 line. Data source: Cboe Global Markets (NYSE:CBOE). Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
The Economic 3-Legged Stool: Financial planners use the 3-legged stool analogy to describe sources of retirement income (Social Security, personal savings and retirement plans). Together they provide stability but if one breaks, the stool becomes unbalanced. After last spring’s pandemic scare, the market seems to have stabilized and advanced upon its own three legs—fiscal stimulus, an accommodative Fed, and the optimism of a post-pandemic economic surge. For many months now, these legs have stood firm. But how long can they continue without at least one leg getting wobbly?
The problem with the market-stool analogy is that each of these economic legs affects the others. For example, Goldman Sachs recently updated its 2021 forecast to reflect economic growth of a whopping 8%, and a 10-year Treasury yield of 1.9% by year’s end. Can we get there without serious inflationary pressures? And can the Fed really keep the front end of the yield curve at near-zero in the face of inflation? Plus, the current rally has seen an expansion of P/E multiples. Some Tech sector stocks have already begun to buckle under higher Treasury yields. Can the market absorb higher Treasury yields? And all that stimulus will at some point need to be funded. With the Biden administration reportedly planning to unveil the first major tax hike in nearly 30 years, including higher corporate taxes and taxes on high-income earners (see more below). It’s no wonder, then, that the rally has wobbled at times.
The Eye of the Beholder: Speaking of inflation, the dreaded “i-word” might figure prominently in this afternoon’s post-Fed meeting statement and press conference. Since its last meeting in January, the 10-year yield has risen over 60 basis points. Although the latest reading on the Consumer Price Index (CPI) came in at 1.7%—up a bit, but still below the Fed’s stated 2% inflation target. But as many of us can attest, official inflation data includes many assumptions that don’t always reflect the true level of personal inflation. For example, last week’s CPI showed a rise of 0.2% rise in housing and 0.3% in so-called “owners’ equivalent rent.” But the latest S&P CoreLogic Case-Shiller 20-City Composite Home Price Index ($SPCS20R) points to a year-over-year rise of about 10%.
Inflation, if left unchecked, can erode the value of assets and lower purchasing power. On the face of it, the CPI and 10-year Treasury yield are roughly equal, so it’s tempting to assume interest rates are currently keeping pace with inflation. But that assumes the CPI accurately reflects changes in the true cost of living. Consider listening in for Chairman Powell’s thoughts on inflation and Treasury yields.
Taxman Knocking? As we mentioned above, media reports say the Biden administration is set to propose tax increases. Higher taxes could be a blow for the market, because most analysts’ earnings projections pencil in the current corporate tax rate. If it goes up, that could take a few cents off of projected earnings for many corporations, which might mean reassessing valuations. Companies earning a higher percentage of their profits at home—small-and mid-caps come to mind—might feel more of the pain from any rise in business taxes.
We’re a long way from anything solid on this front, obviously, and a lot of people will probably wonder if there’s the political appetite or ability to get any kind of tax hike through Congress as the country continues to struggle with COVID. Still, as investors, it’s best to prepare for any possible scenario and keep an eye on where this tax conversation goes, if anywhere. Because one reason (among many) that we have higher valuations now than a few years ago is arguably the lower corporate tax rate. The rate before 2018 was 35%. Biden’s proposal isn’t expected to go that high, but could certainly be above the current 21%.
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