Last week was rather quiet for both the bond and equity markets. There was little new economic news for investors to digest and act upon other than some earnings reports. The good news for the bond market was its ability to hang onto the gains of the prior week. There was little profit taking, which is likely a sign that market participants have grown comfortable with the prospect of future Federal Reserve short-term interest rate increases. It is likely that by the end of this year the Federal Funds rate, which is currently at 1 1/4%, will be raised to 2% through a series of ¼% increases. This will likely have no long term impact on the bond market as the long end of the yield curve has already factored in the Fed interest rate increases. Right now it would appear that the only thing that could derail the bond market is a renewed concern over inflation.
Although it is likely that the Federal Funds Rate could reach 2% by the end of the year, the bond market could ultimately withstand an increase to 3%. An increase in the Federal Funds Rate from 1% to 3% would simply address the over accommodative monetary policy that has been in place for the past year or so. A 3% Federal Funds Rate is still relatively low, but closer to historic norms.
This week the markets will have plenty of new economic data to digest, as well as continued earnings reports. To date, earnings reports have generally met expectations, but this is not necessarily a good thing. In order to maintain a bullish stock market, earnings need to exceed expectations, which have become increasingly difficult for corporations to accomplish.
Economic data of interest this week will include:
Retail Sales on Wednesday – There is an expectation of weakness, particularly following reports form Target and Wal-Mart.
Consumer Price Index (CPI) on Thursday
Producer Price Index (PPI) on Friday
The CPI and PPI reports will be very important indicators of the direction of inflation. It is the fear of inflation that will drive the long end of the bond market to higher yields. Conversely, if the perception is that inflation is not a concern, we may see long-term yields drop further, even as the Fed raises short-term interest rates. In our opinion, we are likely to remain in a period where short-term interest rates are on the rise and long-term rates remain stable. Ultimately, this will result in a much flatter yield curve.
MUNIS - The municipal bond market has rallied from short-term lows and should continue to remain strong as new issue supply is very low.
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