Covenant Weekly Market Synopsis for September 22, 2017

September 25, 2017

Same ol’, same ol’ equity markets…another week and more record closes for the DJIA, S&P 500 and Nasdaq stock indices. Although stocks didn’t close the week on their highs, the S&P managed to move ahead by 0.1%. Beneath the tranquil surface there were some less obvious short-term (thus far) changes to the market’s texture:

  • Small capitalization stocks caught a bid and jumped 1.3% for the week (small cap stocks were one of the best performers following President Trump’s election, but year-to-date have only advanced 7.9% vs. their large cap cousins’ gain of 13.4%).
  • Value stocks, which are significantly underperforming Growth stocks thus far this year (7.1% vs. 19.9%), rose 0.5% vs. Growth stocks declining by 0.2%. The primary beneficiary were bank stocks, which counterintuitively rose even as the yield curve flattened. (Note: banks benefit from a steeper yield curve because they borrow money at short-term rates and lend at long-term rates; the flatter the curve, the smaller the spread which reduces bank profits, all else being equal).

Among international stocks, Japan was the standout adding 1.9%, Europe tacked on 0.7%, and Emerging Markets were flat. The real action last week was in interest rates, which saw the yield on the 10-year US Treasury bounce off a low of 2.1% to close the week at 2.25%. The yield on the 30-year UST also moved higher, but only by 0.05% resulting in a continued flattening of the yield curve. Precious metals were negative for the week (gold -1.7%; silver -3.4%). Crude gained 1.5% to pierce the psychologically important $50 level and at Friday’s close was trading at $50.66 per barrel. Also of note, the lack of volatility in the market is reflected in the VIX Index, which declined 5.7% on the week to an almost implausible level of 9.59.

For more detail on weekly, month-to-date and year-to-date asset class performance please click here.

The Fed’s Hint on the Business Cycle – Last week’s Federal Open Market Committee (FOMC) meeting was not as much of a “nothingburger” as many expected it to be. Yes, the FOMC announced they would begin reducing the size of their balance sheet at both the pace and magnitude as previously discussed. But, the FOMC caught the market offside relative to their future targets for the Fed funds rate. Rather than reduce the number of rate hikes through 2018 (as some expected given relatively weak economic data releases of late), the FOMC stuck to their rate guns and forecast a rate increase this December followed by three more hikes in 2018. The chart below shows the shift in implied probabilities for a December hike from approximately 54% before the meeting to above 65% following the meeting.

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Source: FTN Financial

The combination of these hikes would result in a 1% increase in the Fed Funds rate over 12 months, slightly faster than the pace of rate hikes over the last 12 months. Notably, irrespective of the move in implied probabilities for a rate hike in December, the market is not buying what Chair Yellen and the FOMC are selling longer term – currently, the market is pricing in only one rate hike in 2018.

It remains to be seen if the economic data will support the FOMC’s target rate moving from today’s level of 1.25% to 2.25% by the end of 2018. However, in an apparent acknowledgement of lower overall economic growth potential, the FOMC’s new median forecast for the “terminal” Fed Funds rate unexpectedly fell from 3% to 2.75%. It may not seem like much, but the move reflects reduced forecasts from several FOMC members that had been holding on to the 3% forecast for a year or more. It is called the “terminal” rate because it is the highest rate the FOMC believes they will reach before the business cycle turns and they begin reducing rates to stimulate the economy.

Comparing the FOMC’s planned rate hike schedule to their estimated terminal rate provides perspective on the FOMC members’ beliefs about where we are in the business cycle. Consider the following:

  • The Fed intends to raise rates to 2.25% by the end of 2018 (four rate hikes in the next year).
  • The Fed’s median forecast is for rates to reach 2.75% in 2019.
  • The Fed’s estimate of the terminal rate is 2.75%.
  • Thus, two rate hikes in 2019 will mark the end of rate tightening and the beginning of the end of the economic expansion for this cycle.

According to this calculus, the FOMC believes the economy will continue to expand for another two years, which is good news (to the extent you trust their forecasts). Just keep in mind that financial markets typically begin sniffing out a recession about one year before it occurs.

Be well,

Jp.