Week ahead will tell whether markets challenge Fed

22-05-2016

Week ahead will tell whether markets challenge Fed

The key to the coming week will be about whether markets can absorb the Fed's rate hike message without getting indigestion. The central bank bombarded markets in the past week with the message that it could raise interest rates for the second time in nine years as early as June, if the economy continues to improve as expected. What was different in its message was the new urgency of the timing, made clear in the minutes from its last meeting and in the comments from Fed officials. So there will be much interest in the handful of central bank speakers in the coming week, with particular focus on Fed Chair Janet Yellen, who will be at Harvard on Friday afternoon. Yellen is receiving the Radcliffe Medal, and she will also be interviewed by economist Greg Mankiw. There are also a few economic reports, including Monday's Markit PMIs for the U.S., Japan and Europe, and U.S. advanced international trade data Wednesday and U.S. durable goods Thursday. A smattering of companies also report earnings, with a few remaining retailers — Costco, Tiffany, Best Buy, Abercrombie & Fitch and Dollar General, among them. But the market's very behavior will be most important, and whether it prices in the Fed's rate hike without turning violent. "For me, that's probably the biggest risk. It looks like the growth numbers are lining up for a 2 (percent) handle for the second quarter which looks like plenty. ... Short of a real disaster in markets, I think the Fed is going to have to look through this market thing and not get pushed around by the markets all the time and get scared into not doing anything. I think market reaction in the last couple of days is encouraging, but maybe that means the market doesn't believe them," said Robert Sinche, global strategist at Amherst Pierpont Securities. Odds of a Fed rate hike were about 30 percent for June on Friday, from just 4 percent the week earlier, according to futures markets. July odds were about 50 percent. The stock market in the past week was turbulent, but the S&P 500 finished the week slightly higher, with a gain of 0.3 percent to 2,052. The Dow fell slightly, however, ending at 17,500, a decline of 0.2 percent for the week. But on Friday, all major stock market indexes rose, and a rally in tech pushed the Nasdaq 1.2 percent higher. It finished at 4,769, a gain of 1 percent for the week. The big move came in the Treasury market, where the 10-year yield rose to trade at 1.84 percent late Friday, from 1.70 percent the week earlier. The two-year yield also climbed to 0.88 percent by Friday. The dollar index rose 0.8 percent for the week, with the dollar rising against most currencies. "It's going to be a fairly volatile summer," said Daniel Katzive, head of North America foreign exchange strategy at BNP Paribas. He said there could be big moves in the currency market but perhaps not much difference in levels in the next couple of months. "We'll have a lot of choppiness. It's not going to be a low-volatility summer. The levels of the dollar Memorial Day may look very similar to what they look like Labor Day. ... We might not be getting anywhere on net." Katzive said BNP's base case is that the Fed will not hike this year, or even next, because the economy is not quite strong enough. He said the central bank's rate rise talk could restart the negative feedback loop that took place this year, when a strong dollar leaned on emerging markets currencies, including the Chinese yuan, and commodities prices, creating tight financial conditions and economic weakness. "I think what's going to happen is the market's going to try to price Fed tightening and see how sustainable that is. We've seen the feedback loop operating over the past six months. The Fed sounds hawkish. The dollar goes up, rates go up and that starts to feed back into the market," he said. He said the market did manage to take the fourth-quarter rate hike in stride. "We think the data is going to be too mixed, and we think financial conditions won't allow it. But nothing is set in stone. With the Fed, if financial conditions are better and the data is better, then they have a window ... the world is not a predictable place." Some economists and market pros have cheered the Fed for hiking rates because they see the economy as strong enough, and believe it's time the central bank removes some stimulus. They believe the market reaction does not have to be negative. "The Fed has to do this," said Tobias Levkovich, Citigroup U.S. equity strategist. "Will the Fed raise rates because the economy is strong, and earnings are going to pick up? That's not bad. ... It's still early in the stage of tightening where you can't say: 'This is going to kill the market.' It's not usually the second or third rate hike that's going to do that." Levkovich said the market could pull back but he sees that as temporary and added the expected volatility this summer should bring buying opportunities. He said he's watching one indicator that is signaling that stocks could face choppiness. When the S&P stocks are highly correlated, the market usually does better. But currently, he says stocks are just about 20 percent correlated to each other, indicating there could be a rough spot ahead. "That could suggest some macro dynamic could throw you off. It could be the dollar moves a certain way, or oil throws it off. That would be why we're saying buy on weakness," he said. Levkovich expects the S&P 500 to end the year at 2,150. "I'm less freaked out by Fed issues other than you might have to position portfolios differently," he said. "When the Fed was raising rates and bond yields were moving up, traditionally defensives don't do well, and more cyclical stocks tend to do better and financials do better," he said. For example this past week, defensive utilities were the worst performers, down 2.4 percent. Tech, helped by a rally in semiconductors, was one of the better-performing sectors, up 1.4 percent, the same as the gains in financials. "If the U.S. does well, the rest of the world benefits. It may not be that disruptive to the dollar. Bond yields around the world could edge higher too. It's not just that U.S. bond yields go up, it's the differential. ... There was a sense the dollar will go up forever. That was the view six months ago," said Levkovich. G-7 finance ministers will meet over the weekend, but strategists are not looking for any news from there. "I think they're just doing the normal dance. They'll talk about terror financing in light of what just happened. They were going to do it anyway," said Sinche. "They don't really have any answer on fiscal stimulus. It's actually pretty depressing. You would think they would have some sort of initiative, pledges." Repeatedly, central bankers have called for fiscal stimulus programs to nudge the world's slow-growing economy. "It's kind of mind boggling when you think about it. ... You've got close to zero borrowing costs, monetary policy that's tapped out and nobody wants to discuss fiscal stimulus at all," he said.