2013 Mid Point - Where Are Markets Headed For the Remainder of The Year?

Today is the last trading day of June. Monday is July 1st and the first trading day of the 3rd quarter and the start of the second half of the year. The first half of the year could be characterized as successful from the Feds perspective as its policy of quantitative easing resulted in record low interest rates as well as the best first half for equities since 1999. Mortgage rates remained at record lows and more homeowners were enticed to refinance their existing loans or take out new loans to purchase property. But as we look forward to the second half of the year, what should we expect from the bond market as well as the equity market?

June Ended with a Thud Amongst Increased Volatility and Rising Rates

On June 19th the Fed issued its policy statement and Fed Chairman Ben Bernanke gave his post meeting press conference. It did not take long for markets to start deteriorating. The equity markets sold off and effectively ended a never ending rally, finally giving investors the pullback they had been clamoring for. Interest rates had been rising but the chairmans words were fuel for the fire and treasuries sold off dramatically spiking all interest rates with them including mortgage rates. Most strategists conveyed that rates could and should rise. It was how fast rates started rising that most strategists warned about. In 2 months time mortgage rates rose 1%. ( See an earlier June article about the impact of the rise in mortgage rates on consumers.)

Looking Forward: The Bond Market and Interest Rates

The 10-year treasury sold off on the final trading day of June and closed with a yield of 2.519%. The yield is 0.81% higher than 6 months ago. Because so many rates are predicated on the 10-year treasury yield, all consumer credit is affected particularly mortgage rates. The biggest fear is that rising rates will harm the nascent housing recovery. This is probably a legitimate concern. However, it is no bigger a concern than the lack of participation by first time homebuyers squeezed out of the market by large investors such as Blackstone Group buying up properties as investments and causing the prices to become less affordable. The combination of the two dynamics will cause the housing recovery to stall out. Going forward most strategists see interest rates as range bound. It doesn't seem logical that rates will rise with such an anemic economic recovery. The problem is that there are other forces at work that will affect bond prices. The least of which is created by the markets themselves. The sentiment in the market place that rates must go up will ultimately cause them to rise. Money managers are advising clients to get out of bonds and rethink their portfolio mix. Once a sentiment takes hold in the market place it is very difficult to reverse. As a result, despite a weak economy, interest rates will continue to rise and the Fed will be helpless to stop it. This week saw many Fed governors come out publicly to calm markets after the firestorm created after Bernanke's testimony. The governors were trying to talk markets down. Although rates ended off their highs, the markets seemed somewhat unimpressed with these governors soothing words. 

Looking Forward: The Equity Markets

After having an impressive first half of the year, equity markets stumbled in June and experienced the kind of volatility traders love and investors lose sleep over. The equity markets were on a nice trajectory through the first 6 months of the year and then June hit and the markets lost their composure. A nice 6 month chart of the Dow Jones Industrials reflects the change. The equity market has a nice gradual slope from January to May, fighting off the sell in May crowd only to get brought back to reality by June swoon. June actually produced a negative return for the major index. Again, Bernanke's words after the Fed meeting caused markets to swoon at the thought of an end to quantitative easing. That and weak data out of China, which is now more important to investors than anything else, was enough to produce the pullback that market participants had been calling for. The equity markets, unlike the bond market, seemed impressed by the soothing words of the other Fed governors and rallied the final week of June to avoid an even worse June performance. Going forward, how effective will Fed speak be to calm and talk up equity markets? As the market is a discounting mechanism and QE "forever" seems to have not only been priced in to the markets but even lost some potency, and with earnings growth outlooks tempered but not really priced in, equity markets are facing some serious headwinds in the second half of the year. As earnings disappoint equity markets will likely give back some of the multiple expansion they experienced the first half of the year. Multiple expansion is only legitimate if forward guidance can justify it. With more companies lowering expectations, beating lowered expectations will not alone cause markets to cheer at these elevated levels.

Forecasts and Guesses For The Second Half of The Year

The tone of this article at best is sober so the forecasts should be equally sober. The 10-year treasury will continue to struggle and its yield will rise to end the year at the psychologically important level of 3.00%. There will be fits and starts but the yield will have a positive slope and not for the right reasons.

The equity markets, despite the bulls incessant calls for more gains, will fall to end the year, and this will be a good thing. Look for the Dow to end the year around 14,000, the S&P 500 to end at 1,500, and the Russell 2000 to end the year at 850. There is no technical or logical reason for these numbers other than the rationale that investors will increasingly agonize over the Feds next moves and will start to look less favorably on the impacts of QE and price in negative concerns.

Immediate Reaction to Fed Statement and Bernanke's Discussion

The reaction to the Feds statement and particularly the Fed chairmans comments afterwards was dramatic. The equity markets sold off dramatically and the treasury market sold off with the 10-year note yielding 2.32% rising 12 basis points. Mortgage rates are likely to reflect the 10-year note sell off on Thursday. Mortgage rates are likely to rise at least 25 basis points as a result.

The change in language by the Fed that may have spooked the markets was the Feds description of the waning risks to the economy. This is different from previous language that described continued risks to the economy. Also, Mr. Bernanke was vague if not completely opaque regarding President Obama's comments to Charlie Rose of PBS just days earlier regarding his future with the Fed, which most expect to end when his term ends in January 2014.

Two Fed members (Bullard and George) dissented regarding the Feds policy.

FOMC Meeting: Its Impact and the Expectations

The Fed concludes its two day meeting Wednesday, June 19, with much anticipation. All eyes are on the Fed chairman and whether he will give more insight in to the possible reduction of quantitative easing, now popularly referred to as "tapering".  The financial community and the broader community can thank the media for yet another catch phrase to banter about, not unlike formal popular phrases such as "irrational exuberance", "fiscal cliff", "new normal", and acronyms like "BRICs", "PIGS", and "ZIRP". Although these catch phrases typically go by the wayside after their usefulness runs its course and the media gets exhausted, taper may actually hang around a bit longer than the others. Although there are no real expectations that the Fed will announce a beginning to tapering of the existing QE policy at this meeting, there are growing concerns that inevitably the Fed will have to taper at some point in the future. There are heightened concerns that as a result of the impending end of Ben Bernanke's tenure there will be a "handing off" of sorts of the current policy to Bernanke's successor with at least some indication that an exit is being considered by the current Fed members. This concern is reflected in the bond market through rising rates and in the equity markets through increased volatility.

The impact on the bond and equity markets from the Feds statement may be muted. Bond yields have risen substantially the past 6 weeks and equity markets have seen increased volatility, while rising back to the former highs of the recent past. Although economic data such as labor market and real estate market data have shown relative improvement, the metrics set by the Fed which will drive the decision making policy have not been met. Unemployment still rests higher than the Feds target and inflation has not come close to the Feds desired target. With regards to inflation, if there is any real concern it's that it may be too low. There is increasing evidence that deflation may become a bigger concern than previously thought. Few anticipated that the result of Fed money printing (QE) would be falling prices, but inflation metrics such as PPI and CPI are reflecting weaker prices not stronger prices. This would be a dangerous development as deflation destroys what makes credit markets and the US economic system work. In a nutshell, increasing prices make borrowing and using leverage economically viable by effectively lowering its cost. Deflation eliminates or at least mitigates this process. As such, it seems unlikely the Feds hand will be forced to announce any concrete plans to begin tapering and the markets reaction to the statement should be muted.

The markets expectations of the Fed are another matter. The Fed is not entirely in control of market behavior or market sentiment, for that matter. Regardless of the Feds statement, the market may decide that it will move on without the Fed and price assets without considering Fed comment and guidance. The market will ultimately decide whether it trusts the Fed. The market is seeking clarity from the Fed after many Fed members have made both dovish and hawkish statements about Fed policy going forward. This market uncertainty causes the rise in rates and the volatility seen in the equity market. It will be the Feds job to soothe markets by clarifying its position on current policy and its future course. The Fed chairman has been doing this for nearly eight years now and is quite adept at it. Ben Bernanke will try not to add additional uncertainty to the market and will seek to allay any fears the market has regarding current policy and the transition from his leadership to his successors leadership.

Here We Go Again: Mortgage Rates Are On the Rise. What's the Impact On the Market?

After seeing rates hit all time lows on the 30-year fixed mortgage, rates it seems are starting to move higher. The press and media are reporting that we're seeing the end of the 30 year bull market in bonds and that rates are going higher from here. Or at least they are not going any lower than what we've seen the last several years. This may or may not be the case. Rates have risen only to come back down again as soon as additional weakness in the economy has surfaced. To be sure, if a sustained weakness prevails in the stock market, the bond market could see renewed interest by safe haven seeking investors. Just the same, what do rising interest rates mean to the average homeowner and the housing recovery?

Typically, rising rates are not beneficial to the real estate market. Higher mortgage rates mean higher payments and less purchasing power for buyers and less incentive for homeowners looking to lower their monthly obligations through a refinance. All of these things result in less economic activity. Less purchasing power means fewer affordable homes for first time homebuyers, a staple of a healthy real estate market. The ripple effect of fewer home sales is difficult to quantify but it can mean fewer sales commissions to realtors and loan agents, fewer sales of furniture and other housing related items, and fewer taxes collected by local governments. The impact can be significant. As rates have been extremely low for some time now and many borrowers that could and did take advantage of the low rates, sometimes on multiple occasions, borrowers of all kinds have become very sensitive to rate movements. Modest rate increases can dramatically affect lending volume, as evidenced by the Mortgage Bankers Association weekly mortgage updates.

Recently, the rise in rates has garnered a lot of attention and created much consternation in the investing community. Many analysts insist it's not rising rates that are causing them concern but the rate at which the rise has occurred. Since the last Fed meeting in the first week of May, mortgage rates on a 30-year fixed mortgage have risen just shy of 1%. For a 30-year conforming loan amount of $417,000, the interest and principal payment would rise just over $29 with a rise in the rate by just 0.125% or 1/8 of 1.0%.  This does not sound all that impressive or substantial. However, to put this in to context, this rise would result in a loss of purchasing power of just over $6,400. Still not impressed? This was by just an 1/8 of 1.0% rise in rates. Rates have risen 7 times this amount by 7/8 of 1.0%. The loss in purchasing power by this move in rates is $41,960. Still not impressed? This is in a month. Now you're impressed. This is why analysts are claiming it's not the rise in rates as much as it is the rate of the rise. If you're a first time homebuyer and you waited a month to move forward with your purchase recently, you were just priced out of the market. So what would be the alternative? Either prices have to come down to meet this new economic reality or fewer homes are sold and the ripple effect discussed earlier takes effect. Neither alternative are that attractive or appealing. For the prospective refinance borrower, these types of moves are deal breakers. Ironically, it's environments like these that often times get borrowers off the sidelines and motivated to effect a transaction. What is so alarming to analysts is how quickly things can turn and how fragile the economy may be to any hiccup in the recovery. For example, a misstep by the Fed in its policies or a black swan event or exogenous event out of our control.

Interest rates will probably rise at some point to what economists describe as normal levels and this will be healthy for the economy. Artificially low rates can cause imbalances and distortions in the economy that may be unanticipated. Ideally this rise will occur gradually and cause few disruptions to the economy. Rates are still low by historical standards and most homeowners should still take advantage of these low rates to lessen the burden of their mortgage payments. Housing prices should find their equilibrium in a rising rate environment where first time homebuyers can successfully purchase a home that is within their budgets.

The Fed Should Taper While Confidence is High

The Federal Reserve would be wise to consider tapering economic stimulus while investors have confidence in the approach and its results. Waiting too long could have deleterious results. Two negative outcomes immediately come to mind. The first would be a bigger equity market correction than necessary and the second would be a more dramatic spike in interest rates.

What is With the Value of Investor Confidence?

In the investing world investor confidence reigns supreme. It is always subtly present no matter how discrete. Every tool used by the Fed in supporting the economy and the markets relies on it. Why is this the case? Shouldn't markets be more rational? Not necessarily. Because markets are influenced by humans and humans are emotional, this tends to have a big impact on how markets behave.

Strike While Confidence is Still High

Friday, the equity markets sold off and many investors were rattled, as reflected by the biggest losses coming at the close. After two weeks of talk of possible early tapering, investors finally seemed to embrace "sell in May". Despite the late weakness in the equity markets, investor confidence remains high and the Fed is still getting the benefit of the doubt regarding the efficacy of its economic stimulus known as quantitative easing (QE). It's not too late for the Fed to taper and have the markets interpret it as the Feds confidence the economy is on a self sustaining path of growth. By doing this, it could be that markets rally in the face of tapering as investors see better economic growth and therefore discount higher future earnings. One negative alternative mentioned at the outset however is that investors lose confidence in the Feds approach and believe the Fed is being forced to taper before it wants to. This is a scenario where markets may sell off and possibly dramatically. Under this scenario, it's possible the bond market sells off and yields spike as a result and that the equity markets sell off  as investors seek the safety of the sidelines looking to book first half of the year gains. Early year gains in the equity markets create an environment where investors are more inclined to book profits and ride out a possible market correction which only exacerbates a sell off.

For this reason, it would be wise for the Fed to consider tapering earlier rather than later. If investors lose confidence and markets start to decline, tapering by the Fed may only exacerbate declines and result in harming both future economic growth and employment. Unfortunately, this is the part of the whole process that was expected to be the hardest to manage, the eventual exit of stimulus.