U.S. stock indices ended mixed on Tuesday as the S&P 500 and NASDAQ Composite gained some ground, while  the Dow closed slightly lower; we’ll just have to wait for the third return to 11K in 10 years. 

The broad market hovered around the cut line for most of the session as European government-debt concerns returned to hold sentiment back, but stocks caught a slight bid immediately following release of the FOMC minutes.  (The FOMC is the Federal Reserve’s rate-setting committee and the minutes are the notes from their most recent meeting.)

The Fed talked about how they believe a lingering high jobless rate will curb the recovery and also trimmed their GDP estimates along with their inflation expectations.  Traders heard that and read:  ultra easy money will continue. 

Stocks would have probably recorded a more substantial rise if not for renewed debt concerns in Europe – we’ve talked about how this issue isn’t going away.  Right now the Greek government doesn’t like the fact that the IMF is involved, which means they’ll really (as opposed to just the old nod to EU officials) have to rein in spending.  As a result, no one is totally sure there is a financial-aid package for Greece in place.  Of course Germany and France, the two strongest economies within the Eurozone, will ultimately backstop Greece’s financial needs, but the issue is a bit more precarious than it was at least perceived to be just a week ago.

Financial, utility and basic material shares were among the six of the 10 major sectors that closed higher on the session.  Telecom shares led the three sectors that fell; industrials ended the session flat.

Market Activity for April 6, 2010

Interest Rates in the Current Environment

As we touched on yesterday, we’ll have this drumbeat of U.S. government debt issuance for a long time.  This week $80 billion, for the year $2 trillion, and if the labor market (the tax base) doesn’t pick up quick, and grow consistently, the Treasury will be issuing $1.5-$2 trillion in debt per year as far as the eye can see – tax revenues won’t be sufficient to even come close to our gargantuan spending plans. 

We have a lot of economists running around talking that this recovery is normal, meaning it has the legs to last for years, yet the marketplace seems quite concerned about a 4% 10-year yield – that doesn’t seem to suggest a durable expansion is upon us.  For perspective, the average yield on the 10-year Treasury over the past 50-years is about 6.85%.  If the market actually believed this economic rebound could sustain growth after a normalization in rates, then the marketplace would celebrate long-end yields of

5%-plus as confirmation of the growth story; there certainly wouldn’t be any concern of a 10-year yielding 4%. 

I listened to a strategist on one of the financial shows Monday night refer to strong economic growth and stock market returns during the 1990s even though interest rates were much higher than they are today – suggesting higher rates won’t hurt this recovery; he’s obviously a believer in the durable expansion story. 

Indeed, rates were normal during that decade as the 10-year yield averaged 6.58%.  But we need to understand that interest rates were trending lower during that decade too, falling from 9% in 1990 to 6% in 2000 (same can be true for the 1980s, a period in which long-end rates averaged 10%, but again they were falling – down to 9% at decade’s end from 15% in 1981); today we pretty much have only one direction to move, and that’s higher.  (Of course, I’m speaking on a slightly longer-term basis; over the very short term, one cannot ignore the likelihood that interest rates could very well move down again, after a brief jump, as the economic challenges are unlikely to evaporate anytime soon – meaning, we’ll have another round of the safety trade to get beyond.)

What’s more, and the important point, household debt levels as a percentage of disposable income averaged 85% in the 1990s (75% in 1980s); today we’re in record territory of 125%.  The unemployment rate peaked at 7.8% in the 1992 and was back to 6% two years later (in the 1980s it peaked at 10.8% in 1982 and was down to 7% just 18 months later); today we’re at 9.7% and on the current policy path it may take several years just to get back to 7.5% -- that’s the Fed’s forecast. 

The point is: this economic environment can’t handle normalized interest rates, and the federal government certainly can’t handle it as debt servicing would skyrocket – and Bernanke & Co. know it.  That said, I believe the process of interest-rate normalization is both inevitable and necessary. 

The process is inevitable because the longer the Fed artificially holds rates lower, the greater the possibility that harmful levels of inflation will occur.  In addition, when the Fed does begin to tighten, either by choice or by force, one major demand source for Treasury debt will disappear – the Fed’s ZIRP (zero interest-rate policy) has created a pretty little circle as banks can borrow at zero from depositors and make a nice interest margin by buying Treasury debt. 

The process of interest-rate normalization is necessary because we need higher interest rates to wash out the excesses that remain from the previous period of Fed mistakes, and savers need to be rewarded – nothing rewards the saver like reasonable deposit rates.  Until this occurs, economic distortions will continue. 

The problem of course is we’ll have another round of economic damage to get past when this process occurs.

FOMC Minutes

The release of the Federal Reserve’s minutes from the March 16 FOMC meeting showed nearly all of the committee members were in favor of maintaining the pledge to hold their target on the fed funds rate at a historic low.  The market views this “extended period” phrase as a signal that their benchmark rate will remain unchanged for at least 4-6 months.

Now, the minutes also revealed that a number of members noted the Committee’s policy stance was based upon the evolution of the economy rather than a specific period of time.  However, such comments are nothing but words as Bernanke is not about to startle the market in any way – any decision in removing the emergency-level of accommodation will be very well telegraphed and they’ll do it by shifting the “extended period” phrase to something like “for some time.” 

We must acknowledge that besides re-capitalizing the banks, another main Bernanke objective of this ZIRP policy was to push people into riskier assets by making yields on safer asset unappealing – and man have they.  This move into stocks has helped erase $5 trillion of the $17 trillion hit to household net worth that occurred by March 2009 and he isn’t about to jeopardize that repair, if he can help it.

Don’t be surprised to see another hike in the discount rate (the rate the Fed charges banks to borrow from the central bank) sometime over the next two weeks.  That target for the discount rate is generally held at 100 basis points (or one percentage point) above the rate on fed funds.  During the crisis period, the Fed cut that spread to 25 basis points.  On February 19 the Fed raised the discount rate to 0.75%, which increased the spread over fed funds to 50 basis points.  They’ll widen that spread back to 100 basis points over the next few months.  The Fed will use this action in an attempt to assuage concerns that they are very willing to err on the side of keeping policy too easy for too long.

Have a great day! 

Brent Vondera, Senior Analyst

Phone: 636-449-4900