Week Ahead: Fed Sets Path for Markets

The Fed laid the first stone on the path to higher rates with its discount rate hike, giving the markets a new way to gauge the economic recovery.

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As a result, there will be heightened focus on interest rates around the Treasury's auction of $118 billion in notes in the coming week, as well as on two days of Congressional testimony from the Fed chairman himself.

Markets had entered the past week on edge that the Fed and other governments were ready to pull back on the global stimulus that has pumped liquidity into financial markets and greased the skids for the stock market's rally.

Yet, stocks scored a 3 percent gain for the week as fears about European sovereign debt eased and the market took the surprise Fed discount rate hike in stride. Many economists do not expect the Fed to raise its target Funds rate until later this year or even next year. They do, however, expect the Fed to take moves to reduce its balance sheet and sell assets.

"I think we had seen a (stock market) correction because it's the end of the Fed's easing. It's not so much about Greece," said Richard Bernstein of Richard Bernstein Capital Management.

"The question is: 'Are the fundamentals strong enough to offset the presence of rising rates?'" he said. "...My guess is corporate profit growth is going to explode in the first half of the year."

Bernstein said he does not know whether the sell off that took stocks to a level 8 percent below their January highs is yet over. "I do think what we've seen is a very normal period," he said.

Sam Stovall, chief investment strategist at Standard and Poor's, said stocks typically continue to rise after the Fed returns to a rate hiking cycle. He said the Fed initiated rate tightening programs 13 times since 1946. "The market does better than you would expect," he said.

He looked at the average performance of the S&P 500 in six month increments. "It usually goes up an average of 4 percent but after a rate hike it's 2.6 percent," he said.

In the 12 months after a rate hiking cycle began, the S&P 500 was up 6.2 percent, compared to its average of 8.1 percent.

Stovall notes it is also not the defensive groups that do the best. "Tech is the best performing group in the 12 months after the Fed is starting to hike rates, mainly because they have lower amounts of debt," he said. He also said it may be a point in the economic cycle, where companies are willing to spend on technology to increase productivity and save on other expenditures.

Stocks finished Friday modestly higher after starting on a weak note in reaction to the Fed news. The market was higher for a second week after four weeks of declines. The Dow finished up 3 percent at 10,402, while the S&P rose 3.1 percent to 1109. The dollar gained 0.2 percent against the euro for the week. It also rose 1.8 percent against the yen and 1.4 percent against the British pound.

What to Watch

Fed chairman Ben Bernanke gives his semiannual economic testimony before Senate and House committees Wednesday and Thursday, and the markets will be watching what Bernanke says about what to expect from the Fed after the discount rate hike.

The Fed Thursday increased the discount rate by a quarter point to 0.75 percent. The discount rate is the emergency rate the Fed charges banks and does not have a direct bearing on consumer rates or mortgages. The Fed stressed that the rate hike does not mean it will soon raise its target Fed funds rate and it does not expect tighter financial conditions for households or businesses.

"I take the Fed at its word. This doesn't have policy implications. It's part of the withdraw of emergency steps," said Richard Hoey, chief economist at BNY Mellon.

Hoey said besides the Fed, key economic news for markets in the coming week will be the fresh batch of housing data. "I think we'll probably see some improvement in house prices but not necessarily huge. There is a huge amount of excess inventory in the financial sector, but on the other hand, the builders' inventories are down sharply so it's a mixed picture," Hoey said.

Housing data includes S&P/Case-Shiller home prices on Tuesday; new home sales on Wednesday and existing home sales for January on Friday. Durable goods are reported Thursday, and the second look at fourth quarter GDP is Friday. Both consumer confidence and consumer sentiment are out this week, on Tuesday and Friday, respectively. Weekly jobless claims are reported Thursday, as usual.

"You're dealing with a mixed picture. It's true in housing as it is in the overall economy,:" Hoey said.

Washington will provide plenty of headlines for markets this week. Sen. Christopher Dodd, D-Conn. is expected to introduce a new version of a financial regulatory reform bill, and the Senate is expected to take on the jobs bill Monday.

President Obama, in an effort to jump start stalled health care legislation, holds a health care summit Thursday, to which he has invited Republican members of Congress.

Toyota's CEO Akio Toyoda testifies Tuesday before a House Energy and Commerce Committee hearing on his company's response to pedal problems. The Securities and Exchange Commission considers potential changes tot he short sale rule at a meeting Wednesday.

There is also a cluster of major retail earnings reports, including Lowes and Nordstrom on Monday; Barnes and Noble, Home Depot , Macy's and Target on Tuesday; Chico's and Limited Wednesday, and Gap on Thursday.

Rate Watch

Bernstein said one thing investors should watch is the steepness of the yield curve. The yield curve—the spread between yields on the 10-year Treasury note and the 2-year—widened to a historic level this past week. Traders said that record move was a reflection of increasing concern about inflation but also about the huge supply of debt being issued by the government.

"I look at it as an indicator of future nominal growth," said Bernstein. He said as the Fed tightens, he expects the yield curve to flatten out with short end rates rising and long end stabilizing. After the Fed moved the discount rate, the yield curve narrowed immediately, ending Friday at 286 basis points, down from the historic 294 bps of the day before.

George Goncalves, Nomura's head of interest rates in the Americas, said the Treasury's auctions this week follow three less than stellar auctions earlier in the month.

"We're at an interesting point in time with what just happened with the Fed and how auctions have been performing in general. The last couple of auctions didn't so well," he said. "..I think you'll carry over some of that into the auctions next week."

"You have a lot of supply next week and the Fed is taking away some of the easy money on the front end. Risk premiums have to shift back down the curve and that will materialize next week in the auction," he said.

The Treasury auctions $44 billion in 2-year notes Tuesday; $42 billion in 5-year notes Wednesday and $32 billion in 7-year notes Thursday. On Monday, the Treasury auctions $8 billion in 30-year Treasury inflation-protected securities or TIPS, in the first offering of that duration since 2001. "It's a big deal because everyone is looking for inflation protection. It's the longest inflation bond we've had in years," said Goncalves.

Euro Trashed

The dollar was an immediate beneficiary of the Fed's move. The euro ended a sixth week of declines at a level of $1.3595.

"I actually think we're looking at consolidation next week, mainly because we've reached pretty exhaustive levels in the euro and the pound," said Boris Schlossberg of GFT Forex.

"The thing that would drive the dollar significantly higher is much stronger U.S. economic news," he said. Schlossberg said the dollar could still react to risk aversion but it is now trading on growth rate differentials.

"The only bastion of hope for Europe right now is its manufacturing sector," he said. For that reason, German IFO industrial production data Tuesday will be watched closely as will the final revision of German fourth quarter GDP Thursday. If it is strong, that could force a short covering rally in the euro.

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