Interest Rates Headed Higher Yet

Stock & bond markets opened mixed this morning following yesterday’s rout. Currently, the Dow is down 130 points, the S&P 500 is flat and the Nasdaq is up .2%. On the bond side, long-term Treasuries are up about .5% whereas corporates are flat to down.

This morning brought more evidence that the job market remains strong…maybe too strong. Payroll processing company ADP estimates the US economy generated 242,000 new private sector jobs last month. That tally is significantly higher than economists expected. Prior month estimates were revised slightly higher as well. Separately, the Bureau of Labor Statistics says US job openings decreased a bit in January, but are still rather elevated at about 10.8 million. Compared with about 6 million unemployed, the report suggests we are still dealing with a shortage of labor.

In congressional testimony yesterday, Federal Reserve Chairman Powell said it’s clear the economy has strengthened since the beginning of the year, specifically citing the job market and consumer spending. This strength is making it hard for the Fed to bring down inflation, and may necessitate higher interest rates than previously thought. He warned that the Fed is “prepared to increase the pace of rate hikes…”

The Fed-funds interest rate has risen from nearly zero to 4.57% over the past year. A month ago, investors thought the Fed would probably take that rate up to about 4.8% by this summer. But persistent economic growth and stubborn services inflation have obviously convinced the Fed to take rates higher. Investors have now priced-in the expectation for something around 5.6% by the fall.

Higher interest rate expectations de-value existing bonds because investors are looking for new issues with higher yields. So it’s no surprise that the bond market has immediately priced-in the risk of further Fed rate hikes. But the stock market’s reaction is not quite so clear cut. On one hand, it is true that higher interest rates tend to hit stock valuations, though not across the board. And stock traders are somewhat fearful that the Fed could end up pushing the economy into recession. But on the other hand, rumors of the economy’s demise seem to have been greatly exaggerated. Consumer and business balance sheets are relatively strong with little evidence of over-leverage, and of course the job market is tight. So it is not at all clear, despite media headlines, that stocks should be trading significantly lower than current levels.