KanalyBlog

Wild Week For Financial Markets

Investors encountered an interesting week across financial markets as both the U.S. dollar and S&P 500 reached new 2010 highs, stocks later reversed on elevated volume, and Treasuries were bloodied in the wake of tepid auction demand. Economic news was mixed: durable goods orders showed continued strength in the economy, while existing and new home sales suggested that housing remains vulnerable to extended weakness. In addition, members of the European Union and the International Monetary Fund reached agreement on a framework for the potential bailout of Greece, and a South Korean naval ship sunk in the Yellow Sea, possibly the victim of a North Korean torpedo. And one other major piece news...the $1 trillion health care legislation was signed into law.

With so much occurring in a short period of time, market observers struggled to attribute the week's moves in the markets. A couple of major points seem clear, however. First, equity markets continue to show amazing resilience in the face of significant worries. Second, interest rates seem poised to increase as the U.S. Treasury finds it difficult to finance the huge budget deficit.

Why are equity markets performing so well despite the risks? One reason is that corporate cash flow and earnings are impressive, potentially providing the fuel for continued economic growth as fiscal and monetary stimulus begins to wane. Another is that many investors missed much of the rally, are currently overweight fixed income securities, and are chasing stocks higher. Where this ends is anyone's guess, but a significant rotation out of bonds and into stocks would drive the markets significantly higher.

As for interest rates, both the passage of health care legislation and tepid demand for Treasuries this week add to concerns over how the market will absorb record Treasury issuance. Although the Congressional Budget Office stated that the health care bill will actually reduce the deficit, credible market analysts beg to differ, and that's all that matters today. The chart below shows that the Treasury faces difficulty in finding enough buyers for billions in new debt, and rates will need to rise to attract those buyers. This week's rise in rates is only the beginning.

Employment Continues To Improve

The Bureau of Labor Statistics released February employment figures on Friday which showed continued, yet far from robust, improvement. Payrolls dropped by 36,000 in February, nearly half the consensus expectation for losses. In another positive sign, prior month losses were reduced, indicating that the massive layoffs of a year ago have abated. In addition, the unemployment rate was unchanged at 9.7%. Many economists believe the recent figures were negatively distorted by the record snowfall experienced in many areas of the country, leading to expectations of big increases in employment for March and April. That may well be the case, although the percentage of people working part-time for economic reasons jumped by 500,000, causing the broader underemployment rate to rise to 16.8% from 16.5%.

The equity markets cheered the news, with the Dow Jones Industrial Average and the S&P 500 posting 2.3% and 3.1% gains, respectively, for the week. The S&P 500 closed at 1,138 and seems poised to clear the high for 2010 at 1,050. Should the index clear this level, the bull market that began one year ago would have a strong chance of continuing.

However, a cautious approach is still warranted. It should be obvious that much of the recovery in the economy over the last several months is due to the massive fiscal and monetary stimulus programs that will soon end. Despite such stimulus, the economy is still a long way from the robust job creation required to significantly dent the high unemployment rate. And while most economic indicators point to recovery, data from the housing market have taken a significant turn for the worse in recent weeks - this despite loud forecasts that housing had bottomed.

As a result, this economic recovery is much less impressive than those following previous deep recessions, calling its sustainability into question as stimulus fades. Next month, the Federal Reserve will no longer be a buyer of mortgage-backed securities, and most of its emergency programs will have expired. Together with the still anemic pace of bank lending, economic growth faces significant challenges in the second half of this year.