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What a Week: Fed Fallout

Data point to no rate cut anytime soon, hurting bonds, but the stock market keeps on trucking.

Slice and dice the data however you want, but don't expect the

Federal Reserve

to chop away at interest rates anytime soon.

The markets faced that new reality this week as economic data and the Fed reflected strong growth and concerns about inflation. The shift trounced the bond market, as its rally was predicated on a rate cut. Stocks soared to new highs, however, as equities' rally is premised less on a cut and more on assurance that there are no more hikes. Lower energy prices and a strong start to earnings season helped things along as well.

The

Dow Jones Industrial Average

gained 0.1% Friday to close at an all-time high of 11,960.51, its sixth record close in the past 10 trading days. The Dow added 0.93% on the week and squarely put a 12,000 print in its sights. The Dow is now up 11.6% year to date.

The

S&P 500

returns 9.4% year to date, after adding 1.19% on the week and 0.20% Friday to close at 1365.62. The

Nasdaq Composite

gained 0.5% Friday, and 2.5% on the week to close at 2357.29, which equates to a 6.9% year-to-date return.

Bond yields backed up throughout most of the week on hawkish Fed-speak, FOMC minutes from the September meeting and a benign beige book report. The yield on the 30-year bond added 11 basis points on the week to 4.94% Friday. The 10-year note yield jumped 11 basis points this week to 4.8%, and the five-year note added 13 basis points to yield 4.77%. The dollar also strengthened with rate cuts coming off the table.

None of the Fed rhetoric in the past week pointed to rate cuts. Indeed, the possibility of rate hikes may soon become the more favored cocktail talk. The FOMC minutes followed warnings from Fed presidents and committee members that the bond market was too certain about its bet on a sharp economic slowdown and rate cuts. The message couldn't be clearer than hawkish Chicago Fed President Michael Moskow's comments Thursday during a speech in Chicago. Moskow's "current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low."

The FOMC minutes Wednesday were the key turning point for bond traders, as the committee took pains to reverse the notion that concerns about growth trump concerns about inflation. The Fed backpedaled on its forecast that growth would slow rapidly enough to stamp out inflation, an argument the markets embraced this summer ahead of the Fed's August decision to pause in its tightening campaign.

"Members continued to see a substantial risk that inflation would not decline as anticipated by the Committee," read the FOMC minutes.

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As the week progressed, the fed funds futures market brought odds to 0% that the Fed will cut rates at any point this year, and revived the notion of a hike.

After retail sales data came out Friday showing increases in consumer discretionary spending, the market priced in a rate hike sooner than a rate cut -- however slight a chance that may be. The market puts 2% odds of a rate hike at the January FOMC meeting, and 0% odds of a cut at the next three meetings, or through January, according to Miller Tabak. Odds of a rate cut at the Jan. 31 peaked on Sept. 1 at 50%. The market puts 8% odds on a cut at the March FOMC meeting.

Don't expect odds of a rate hike to climb much higher than 2% in the near future, however. Next week's producer price index and consumer price index readings will most likely be weak because energy prices have declined and year-over-year comparisons will be made to the post-Katrina price spikes.

Friday's retail sales resembled the trade deficit report that came out Thursday -- ugly on the outside, but virtuous on the inside. And both reflect the stronger-than-expected consumer. While the headline retail sales report showed a 0.4% decline in September, the drop was due to plummeting gasoline prices. The 3% increase in apparel sales, and 1.1% additions to general merchandise and restaurant sales reflect wage growth and strong labor market conditions, which in turn were reflected in a stronger-than-expected consumer confidence report from the University of Michigan.

The 0.6% increase in building materials sales, and 0.2% climb in furniture sales are yet another piece of evidence that the housing slowdown may be bottoming, and that it certainly isn't causing a consumer-led recession. JPMorgan concurred this week, as the investment house upgraded several homebuilder stocks and suggested a bottom in the housing decline is near. (Homebuilders were hit Friday, however, after

Centex

(CTX)

dramatically cut its second-quarter earnings guidance.)

The trade deficit similarly caused an initial cringe, as it came in for August at a record $69.9 billion, but the numbers reflect a sharp increase in imports; this again points to the ever-spending U.S. consumer, and

Thursday's advance was the most robust of the week.

"Recent data favors nothing worse than a soft landing for the U.S. economy," writes John Lonski, chief economist at Moody's Investors Service.

Oil prices fluctuated this week, however, as the threat of OPEC cuts to supply weigh on the market. Oil finished Friday up 1.23% on the day at $58.57, which is still 1.99% below last Friday's closing price.

Also muddying the waters was a mixed bag of earnings reports.

Alcoa

(AA) - Get Alcoa Corporation Report

disappointed while

McDonalds

(MCD) - Get McDonald's Corporation Report

and

Costco

(COST) - Get Costco Wholesale Corporation Report

blew away expectations.

Economic bellwether

General Electric

(GE) - Get General Electric Company Report

reported improved earnings, but analysts met the numbers and chief executive officer Jeffrey Immelt's positive words on the economy with the usual skepticism. The outlook and the profits just weren't good enough. The company's shares declined 0.75%.

But oil's movement is at the nexus of the soft landing and the market's resilience. Lower energy prices bring shoppers back to the mall, but they are also tightly correlated to inflation expectations at this time, writes T.J. Marta, chief fixed-income strategist at RBC Capital Markets.

As long as oil prices remain relatively low, the Fed has more room to stay on pause without fretting about its credibility. If it spikes, expect inflation fears to swell, stocks to suffer, and Fed rhetoric to reignite the old rate-hike "escalator."

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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