The Week Ahead: Will The Interest Rate Surge Continue?

Since 2008 investors have preferred bonds to stocks. When the valuation difference became compelling, the stock rebound was led by defensive sectors – anything with attractive yield. We are now at a crucial point in this trend. Last week's spike in long-term interest rates has driven the ten-year yield back above the dividend yield on the S&P 500 for the first time since 2011. Abnormal Returns discusses the rarity of this situation, noting, "This relative yield argument has been used by many to get investors to jump back into stocks." See the full post for a more complete discussion and an interesting chart.

With plenty of data to fuel the debate, this week's focus will be on interest rates: Will the surge continue?

The one-year chart of the ten-year yield shows the break out from the recent trading range. You need to look carefully to see the last few daily data points, following a gap.

To set the stage, here are two contrasting viewpoints:

• Top bond managers Jeff Gundlach and Bill Gross see long-term rates as controlled by the Fed. At the start of May, Gundlach stated this viewpoint on several occasions as noted in the WSJ:
  "It's not timely to be betting on higher interest rates," said Jeffrey Gundlach, chief executive and chief investment officer of DoubleLine, a Los Angeles firm with $59 billion under management. He said economic growth remains too soft to allow the Fed to consider cutting back its $85 billion-a-month bond-purchase program known as "quantitative easing," a shift he views as a necessary precursor to any increase in interest rates.
  Gross shared this opinion:
  "Pimco's advice is to continue to participate in an obviously central-bank-generated bubble,'' Mr. Gross said in his monthly investment outlook published last week.
• Economist Scott Grannis contends that the Fed is Powerless to Manipulate Interest Rates.

1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially -- no politics.
2. It is better than expectations.

• The Chicago PMI showed a surprising gain to 58.7, the biggest increase in decades. This matters mostly as a hint about Monday's national PMI.
• Case-Shiller home prices showed a surprising increase. See Calculated Risk for analysis. Dr. Ed, providing this chart, makes the prediction that there will be "no negative equity in U.S. markets in 12-18 months."

• Initial jobless claims disappointed, increasing to 354K. This is replacing a "good" week in the 4-week average that everyone follows to reduce noise.
• Personal income was unchanged, a market disappointment. See Steven Hansen's analysis for trends, inflation adjustments, and year-over-year analysis. Eddy Elfenbein is more encouraged by the result when adjusting for transfer payments. Eddy recommends ignoring the end-of-year "dividend spike" in this chart:

• Pending home sales increased, but less than expected. I am scoring this as "bad" but Calculated Risk sees it as a function of fewer low-end foreclosures.

• The St. Louis Financial Stress Index.
• The key measures from our "Felix" ETF model.
• An updated analysis of recession probability.

1. The S&P 500 is up 46.2%.
2. The unemployment rate has dropped from 9.0% to 7.5%.

• The employment report (F). The Fed is using employment as a benchmark, and so is everyone else.
• Initial jobless claims (Th). After last week's bounce higher, this will command attention even though it is not part of the survey period for the jobs report.
• The ISM index (M). A good coincident indicator of economic conditions. It is threatening to turn negative on manufacturing.

• ISM services (W). Services have become more important than manufacturing, but the series has less history.
• ADP employment (W). A good independent read on employment. This report deserves attention.
• The Beige Book (W). While the information is anecdotal, this is what the FOMC will see at the next meeting.
• Construction spending (M). April data, but confirmation for a key sector.

• What NOT to do

• Find a safer source of yield: Take what the market is giving you!

• Balance risk and reward

• Get Started

• The economy is moving toward a natural growth rate -- greater than now.
• The Fed is trying to create inflation, and they can do it. (See here).
• Investors will be surprised by losses in their bond mutual funds.

1. Stock investors are just waiting for bonds yields to get back above 2% so that they can keep up with inflation.
2. Bond investors will be surprised by actual losses on their statements -- something they have not seen for years.