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What Moves Stocks? It's Still Fears of Rate Hike

MARKETWATCH 12:47 AM ET 5/28/2015

Symbol Last Price Change
GLD 113.89down 0 (0%)
GDX 19.44up 0 (0%)
QUOTES AS OF 04:00:00 PM ET 05/27/2015

"This may pinch." That's what my dentist (and probably everybody's) says when he's about do something that might hurt, like administering a shot of Novocain with that big needle. At least I have a chance to close my eyes and brace myself for the "pinch."

Stanley Fischer, the Federal Reserve's vice chairman, delivered a similar warning Tuesday, and the markets flinched. Currencies, commodities, bonds and stocks all reacted when he commented, "the actual raising of policy rates could trigger further bouts of volatility." This came almost exactly two years after former Fed chief Ben Bernanke set off the infamous "taper tantrum" by letting the markets know the U.S. central bank would eventually begin to slow its heady pace of securities purchases.

Mentioning "further rates of volatility" is tantamount to saying "this may pinch." It's likely to hurt but it's going to happen anyway.

The tangible result was that a the major U.S. stock market averages fell 1% (http://blogs.barrons.com/ stockstowatchtoday/2015/05/26/dow-drops-nearly-200-points-as-merger-monday-stronger-data-fail-to-boost-stocks/), which translated to a not-inconsiderable paper loss of about $250 billion, according to Wilshire Associates. While the impasse over Greece's debt negotiations (http://blogs.barrons.com/emergingmarketsdaily/2015/05/27/avoid-greece-hope-isnt- investable-jpmorgan-says/) continued to loom as a storm cloud on the horizon, the action in other markets provided circumstantial evidence of a shift in expectations on U.S. monetary policy. The dollar rallied strongly, with sharp gains versus the euro and the Japanese yen, with the PowerShares DB US Dollar Index Bullish exchange-traded fund (ticker: UUP(UUP)) surging 1.1%. That would be consistent with less accommodation by the Fed while the European Central Bank and the Bank of Japan maintain their aggressive policies of quantitative easing.

As the greenback rose, gold and commodities such as crude oil dropped. The SPDR Gold Trust(GLD) ) plunged 1.5% and the Market Vectors Gold Miners ETF(GDX) ) shed 3% while the U.S. Oil ETF (USO(USO)) fell 2.8%. Yet despite the slippage in energy prices, economically sensitive transportation stocks remained under pressure, as Michael Kahn discussed in his Getting Technical column Tuesday (http://online.barrons.com/articles/transport-stocks-crack-now-its- time-to-worry-1432672847?mod=BOL_hp_highlight_2).

What's especially striking was the behavior of the bond market. The suggestion of higher short-term interest rates resulted in lower, not higher, long-term bond yields.

This state of affairs is called a flattening of the yield curve. The yield curve is the graph of interest rates of various maturities of Treasury securities. Since intermediate- and long-term interest rates are the sum of expected future short-term rates, the yield curve constitutes the bond market's best-guess forecast.

In simplest terms, an upwardly sloped yield curve, with higher long rates, reflects expectations of higher short-term rates, which would be consistent with continued growth. Conversely, a flatter yield curve reflects diminished expectations about future rate hikes--presumably because the market thinks growth won't be so robust. And, yes, there are listed products to play that: the iPath US Treasury Flattener exchange-traded note (FLAT(FLAT)) and the companion iPath US Treasury Steepener ETN (STPP(STPP)).

After Fischer's suggestion of future market volatility, long Treasuries' yields fell, with the benchmark 10-year note ending Tuesday at 2.135%, a three-week low and down sharply from 2.211% Friday. The popular iShares 20+ Year Treasury ETF (TLT(TLT)), which tracks the long end of the bond market, jumped 1.7% -- equivalent to a 300-point surge in the Dow Jones Industrial Average.

The comments by Fischer and Fed Chair Yellen last Friday point to the initial increase in the federal funds rate target as early as the Sept. 16-17 meeting of the Federal Open Market Committee. Their consistent message that a rate hike is coming later this year can't be an accident -- even though economic growth is likely to be essentially nil for the first half. Revised first-quarter gross domestic product data due Friday should show a contraction at an annual rate of more than 1%. Meanwhile, the latest tracking by the Atlanta Fed (which nailed the softness in the first quarter) is for a measly 0.8% growth rate in the current quarter.

Late Tuesday, it was reported Yellen will skip the late August confab at Jackson Hole, Wyo., where in past years Bernanke would tip future Fed moves in the keynote speech. By avoiding that venue, Yellen maintains flexibility to make a "data dependent" decision that would take in August's employment data due out Friday, Sept. 4. And by then, memories of the lousy first-half will be fading. (Or new fudge factors will be applied to make the numbers look better.)

The markets seem to be adjusting to the expected pinch of the initial Fed rate hike. Stocks and commodities slumped while the dollar jumped. Most telling was the reaction of the yield curve; while the liftoff in rates may be coming, the trajectory after that will be gentle in a tepid economy. At least that was the inference to be drawn from Tuesday's action.

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-Randall W. Forsyth; 415-439-6400; [e-mail]

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