Fears of higher rates returned to haunt the market this week, eclipsing oil concerns as the Fed used the 'I-word' in its policy statement. And just as the Fed said it now has inflation in its crosshairs, the market received evidence that producer and consumer prices are rising more than expected.
For the week, the
Dow Jones Industrial Average
fell 1.7%, closing at 10,442 on Thursday after trading as high as 10,519 intraday. The
shed 1.5% for the week to 1,171 while the
fell 0.7% to 1,991, having closed below 2000 on Tuesday for the first time since November. The Nasdaq also violated its 200-day moving average this week. (U.S. financial markets are closed tomorrow in observance of Good Friday.)
The yield of the benchmark 10-year Treasury rose to 4.59%, off a high of 4.63% on Tuesday but up from 4.51% last Friday.
The biggest drop in the indices was seen on Tuesday. After delivering its seventh 25-basis-point rate hike, the Fed ended the suspense over the so-called "measured pace" it has been using to tighten rates. While the language stays in place for now, the Fed is on the lookout for inflation and the market is adjusting to the prospect that rates will have to go up more than previously thought. Fed fund futures are now pricing in higher-than 50% odds of a 50-basis-point rate hike at one of the Fed's next two policy meetings, on May 3 and June 29-30.
Hit With New Yardstick
The new focus on rates seems to have replaced surging oil prices as the main yardstick influencing the market's mood swings -- at least for now. The price of crude, which reached a high of $57.50 per barrel last week, fell more than $2 from last Friday's $56.72 to close at $54.27 in Nymex trading. Crude oil had slipped to $53.81 Wednesday amid news of inventory buildups and a higher dollar, but came back up slightly after a deadly explosion at a
refinery in Texas.
So a slide in the price of crude oil was barely noticed by anybody. But what of the concerns about higher oil prices, namely, that they would impact economic growth?
Well they will, but that's already been discounted by the market, Wall Street analysts sing almost in unison. And growth is not the concern anymore, it's inflation.
Likewise, there's a shift into which pieces of economic data will matter most to the Street. "Future economic reports will now be analyzed for their potential impact on inflation, rather than whether they imply stronger or weaker job growth," writes Mark Vitner, senior economist at Wachovia.
In other words, the producer and consumer prices indices are now going to be watched more closely than payrolls, as was evidenced this week. On Tuesday and Wednesday, modest gains in the February CPI and PPI -- both rose 0.4% against forecasts of a 0.3% gain -- spooked the markets.
Meanwhile, higher-than-expected weekly jobless gains and weak February durable goods orders in February were largely ignored. Weekly jobless claims rose to 324,000 against expectations for claims to fall to 316,000. New orders rose 0.3% in February, against forecasts for a 1% gain.
Sure enough, the impact of higher energy costs was reflected in the February prices. Crude oil prices continued to surge to record levels during February and March, against predictions that the oil rally had ended. This could have led many economists' forecasts to fall below both the actual readings for the headline PPI and CPI. We might even see some inflated forecasts for the March PPI and CPI as economists try to compensate. Whether forecasts are on target, of course, will depend on what the price of crude does.
But the PPI and CPI also revealed inflationary pressures are present in housing, health care and other nonenergy-related industries. A weak dollar has continued to exacerbate the situation through higher import prices. This week, the buck staged a rally of its own on the prospect that rates will rise more than previously expected.
But dollar bears, such as MG Financial Group chief currency analyst Ashraf Laidi, say that once uncertainty over the Fed's tightening schedule is over, the ghosts of the twin U.S. deficits will come back to haunt the currency.
Meanwhile, the impact of the exceptionally low interest rate environment of the past few years is still being felt in diverse corners, not least in the housing sector.
On Thursday, the Commerce Department reported that new-home sales jumped 9.4% to 1.26 million in February, the second-highest sales growth on record. Economists were expecting a small increase to 1.14 million.
The Philadelphia Stock Exchange Housing Sector's Index rose 1.4% Thursday and gained 0.4% for the week even as yields rose and the Fed put itself on inflation watch.
Economists promise that the housing sector is bound to decelerate with interest rates decidedly on the rise. Other data this week may point their way. The Mortgage Bankers Association said that mortgage applications fell by 9.5% in the week ended March 18, while refinancing applications are 60% lower than they were at the same time last year. U.S. existing-home sales also dropped 0.4% in February, albeit that was a smaller-than-expected decline.
And with long Treasury yields finally rising,
reported Thursday that the 30-year mortgage averaged more than 6% this week, the first time it reached that level in eight months.
According to Morgan Stanley economist Richard Berner, yields will have to rise much more than they have so far. "Although market participants have begun to focus on the chance that interest rates will move higher than they previously thought, they still haven't discounted the possibility that monetary policy might become restrictive," he says.
In the meantime, the 10-year Treasury yield of 4.59% is still a good distance from the 5% where Berner says it would have value.
Will Greenspan's "conundrum" persist? It still is to some degree, judging by the historically modest spreads between two-year and 10-year notes. Hedge fund buying may be responsible, and the funds have been helped by Greenspan himself, says Oppenheimer chief investment strategist Michael Metz.
"Never has the Fed been so early about telegraphing rates changes to the market, that helps speculators," he says.
Still, there is still too much liquidity in the system, and that's creating real "financial stress" in the system, says the notoriously bearish Metz.
story, probes at
, jail sentences at
, writedowns at
-- those are symptomatic of excess liquidity," he says, adding that the current environment reminds him of the days of the near collapse of the hedge fund Long Term Capital Management in 1998.
In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send