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.
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