In A World…Where Interest Rates Go Up

By Ben Norris, Securities Research Analyst, Associate Vice President

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Last week featured a consequential update from the Federal Reserve. The central bank has been the center of attention for investors (even more than normal) for most of 2021 as they wait for a potential tightening of monetary policy. As expected, the Fed decided to keep rates where they are for the time being but are beginning to telegraph a world where interest rates will be higher and the asset purchases by the bank will be lower. Part of the Fed’s update includes “dot plots” or a graphical representation of where Federal Reserve policymakers think interest rates could be headed in the future. This round of the dot plot showed that 13 of the 18 committee members were in favor of at least one increase in interest rates by the end of 2023. Seven members now see an increase in rates by the end of next year, up from just four members who wanted to see an increase in rates in March.

In contrast to the change in posture on interest rates, Federal Reserve Chairman Jerome Powell indicated in his post- meeting press conference that the Fed expected to continue its $120 billion a month rate of bond purchases until “substantial further progress” is made toward the Fed’s goal of achieving maximum employment and sustained inflation of 2%. Investors generally believe that the Fed will “taper” the $120 billion of bond buying before rates move higher but Powell declined to give any insight into when tapering could become a possibility, creating some confusion for markets.

The takeaway from this meeting should be that interest rates are almost certainly going higher, if not by 2022 then certainly by 2023. This reminds me of the movie previews in the 1990s and early 2000s where voice actor Don LaFontaine would begin with the phrase “In a world…” followed by some ominous lead in for a blockbuster action or horror movie. The lead in in 2021 would be “In a world where investors can’t remember what it’s like to buy stocks without artificially low interest rates, markets drift aimlessly, with nothing to push them higher.”

For some investors, the thought of higher interest rates might be scarier than a movie based on a Stephen King novel. In fact, investors under the age of 35 probably can’t remember interest rates much higher than zero. Obviously, rates have been higher in the past. Before the 2008 Financial Crisis the 10-year treasury yielded more than 5% (the current yield is somewhere around 1.5%) and rates were comically high in the late 1970s and early 1980s as the Federal Reserve battled inflation. Higher rates shouldn’t be a scary proposition. In 2021, higher rates are an indication that the American and global economies are finally getting back to normal after two unprecedented events – the Great Recession and a global pandemic. Investors have dealt with much higher interest rates for the better part of a century and re-adapting to those conditions will likely be easier than most investors think.

Still, in the context of one week of market performance, the specter of higher rates had investors spooked. The Dow Jones Industrial Average (DJIA) and the S&P 500 (SPX) were down 3.4% and 1.87%, respectively. The Technology heavy Nasdaq Composite was down just 0.26% while the small cap-focused Russell 2000 was down a spooky 4.17%. All in all, last week was the worst performance for the S&P 500 since February. This was somewhat surprising considering that the index reached an all-time high on Monday.  It’s clear that investors are extremely focused on the Fed’s posture going forward. Strong performing sectors for the week were Technology, Consumer Discretionary, and Health Care, while the Materials, Financials, and Energy sectors underperformed. Technology was the only sector that was able to remain positive for the week.

Economic announcements were abundant last week. Industrial Production increased 0.8% in May as businesses ramp back up and slowly rebuild their workforces. The producer price index, a leading measure of inflation, was up 0.8% in May as inflation remains in the headlines. Retail sales came down 1.3% month over month as the effect of economic stimulus payments wanes. Housing starts, an indicator of future building trends, were up 3.6% in May with demand for single-family homes remaining exceptionally strong.

The coming week has several economic data releases that have the potential to move the markets. Wednesday includes both Services and Manufacturing PMI, which are a broad measure of economic activity. Thursday includes the normal updates on initial and continuing jobless claims as well as a revision to first-quarter  GDP. Finally, Friday will see consumer spending levels, and Personal Consumption expenditures, the Fed’s preferred inflation indicator.

Date Report Previous Consensus
Monday 6/21/2021 None scheduled
Tuesday 6/22/2021 Existing Home Sales (SAAR) 5.85M 5.68M
Wednesday 6/23/2021 Manufacturing Purchasing Managers’ Index  62.1 62.1
Services Purchasing Managers’ Index 70.4
New Home Sales (SAAR) 863K 872K
Thursday 6/24/2021 Initial Jobless Claims 412K 380K
Continuing Jobless Claims 3.52M
Q1 Gross Domestic Product (revision) 6.4% 6.4%
Friday 6/25/2021 Personal Income -13.1% -2.7%
Consumer Spending 0.5% 0.3%
Core Personal Consumption Expenditures (PCE) 0.7% 0.6%

 

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