Rising interest rates and energy prices provide headwinds

Last week equity markets moved decidedly in two directions. At the outset of the week, equity markets stepped smartly higher, and in the process helped to temporarily allay fears that a sharp move lower and retest of 2581 was in the cards after the previous week’s elevated volatility and dramatic pullback. That brief 2-day pause for investors was upended by several themes, not the least of which was the rising yield of 10-year Treasury notes at the close of last week. Equity prices ended the week on a decisively negative note with all three major indices losing meaningful ground while the volatility index (VIX) rose 5.76% to close at 16.88.

Though equity market investors have certainly had plenty of variables to take into account in recent months – variables that have undermined confidence, and triggered a meaningful pullback in prices and a dramatic rise in volatility – rising interest rates have largely been overlooked. That is, until late last week.

Since February 8, when the S&P 500 registered a low of 2581, the yield on the 10-year has risen from 2.85% to Friday’s multi-year high of 2.95%. That move higher in yields has taken the 10-year within striking distance of the all-important 3% level. The last time the 10-year traded above 3% was on December 1, 2013. Many on the street feel as though a 3% yield on the 10-year is a tipping point of sorts. It is considered an important inflection point for a variety of reasons – not the least of which is that it reflects a meaningful alternative to equities for investors. Additionally, given the fact the S&P 500 closed on Friday still off 7% from the highs registered on January 26, we already see a degree of rotation out of equities as investors increasingly have looked to reduce exposure to perceived risk and continued elevated valuations.

Another warning sign for investors has emerged as a result of rising short-term rates, a flattening yield curve. Historically, flattening yield curves, and the potential for an inverted yield curve, speak to late-stage economic expansion and a likely resultant turn lower in economic activity and equity prices.

Though not a certainty of additional weakness in equities, the trends in recent equity and credit market trades do signal a degree of stress in the market.

Rising interest rates not only affect consumers, more importantly, they impact the US Treasury very adversely. Broadly, the cost of borrowing across the entire economic landscape is impacted. Rising borrowing costs, coupled with weak equity prices and elevated valuations, concern over trade wars, and clear signs of rotation out of equities just weeks into Q1 earnings season all call for increased caution.

The rising cost of energy also provides headwinds for investors and consumer alike. As evidenced by the 5-year chart for WTI crude oil below, on Friday crude closed at a multi-year high. Increased US and global consumption coupled with temporarily crippled Canadian production and curtailed OPEC production have all acted to provide additional momentum to rising prices.

Energy is a critical component of inflation. Rising prices has broad implications for consumers and interest rates indirectly as well.

Last week’s economic calendar provided some encouraging data investors. On Monday Retail Sales for March came in at 0.6%. The Empire State Mfg. Survey for April was 15.8, and Business Inventories for February were a solid 0.6%. Housing Starts for March were stronger than expected 1.319 M versus Bloomberg consensus calling for 1.264 M. Also released on Tuesday was Industrial Production data for March. It came in at 0.6% – higher than Bloomberg consensus of 0.4%. Acting as a tailwind for higher energy prices, the EIA Petroleum Status report reflected a draw in all three verticals. Weekly Jobless Claims remained in-channel at 233k – suggesting continued strength in the job market and broader economy.

Highlights for this week’s calendar include the Chicago Fed National Activity Index on Monday, the FHFA Home Price Index on Tuesday, the EIA Petroleum Status Report on Wednesday, Durable Goods on Thursday and GDP on Friday. I expect the economic data to continue to provide a constructive landscape for investors while earnings continue to provide a counter-balance to the heads winds outlined above. Trading will remain trendless as equity markets look to further establish a base with which to trade higher.

Flickr Photo: Michael J. Linden
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