Weekly Markets Commentary — February 21, 2016
David Joy – Chief Market Strategist, Ameriprise Financial
Investors Should Watch Inflation and the Fed’s Timing
The U.S. economy showed further signs of acceleration last week, led by a strong January retail sales report. But this recent strength was also accompanied by evidence that inflationary pressures may also be beginning to firm. The consumer price index (CPI) rose 2.5 percent in January year-over-year, its fastest increase in almost five years. In comparison, its twelve month rate of increase just six months ago was 0.8 percent, although that was due in large part to the 25 percent fall in the price of oil over the previous twelve months. This month, the CPI reflected a 30 percent twelve month increase in oil. The core rate rose as well, however, climbing 2.3 percent, equaling the rate of increase in both August and February of last year, also the fastest rate of increase in almost five years. The headline producer price index was a little more benign, rising 1.6 percent year-over-year in January, matching the December report for the highest reading since September, 2014. But the core rate fell to 1.2 percent, down from 1.6 percent in December, in the process retreating to its level of last September.
Timing of Possible Fed Interest Rate Hikes
These reports were not enough to set off alarm bells among bond investors. The yield on the ten-year Treasury note barely budged on the week, climbing just one basis point to 2.42 percent. The two-year note remained anchored at 1.20 percent. But in her congressional testimony last week, Fed Chair Yellen did say that the Fed would consider raising interest rates at its “upcoming meetings” if the economy continues to firm. The Fed meets next in March, and if three rate hikes are to happen this year, as the Fed has signaled they may, then the March meeting must certainly be considered “live.” The next meeting of the Federal Open Market Committee (FOMC) that is accompanied by a press conference, generally considered the best candidates for policy changes, comes in June, followed by September and December. If the March meeting is not considered “live,” that implies the possibility of three rate hikes being squeezed into the final seven months of the year, something the Fed would likely hope to avoid for fear of creating the impression that in its own mind it had fallen behind the inflation curve.
The Fed Continues to Watch Data
Of course, all of this is subject to what the data reveals. In the three weeks remaining before the March FOMC meeting the most influential data point will be the February jobs report on March 10th. Another month of solid job creation is expected, in the vicinity of 175,000 according to the Bloomberg consensus. But how the Fed views the report may turn on the pace of wage growth. In the January labor market report wage growth disappointed, slipping to 2.5 percent growth year-over-year from 2.8 percent in December. This at least temporarily reverses the trend higher. The February report will help to determine if the January decline was an aberration, or whether enough slack still remains in the labor market to keep wages under pressure. The other data point that will be influential for the Fed is the personal consumption expenditure (PCE) deflator for January to be released on March 1st. This measure of inflation preferred by the Fed is expected to climb 2.0 percent in February from 1.6 percent in January, which would also be its fastest rate of increase since 2012, and in the vicinity of the Fed’s stated target for inflation. The core rate is expected to 1.8 percent, which would also be its largest increase in almost five years.
Investors Keeping an Eye on the Fed
Some insight into how the Fed is thinking about all this will arrive with the minutes from its February meeting to be released on Wednesday. Investor expectations were certainly altered by Yellen’s testimony last week. On the day before her appearance in the Senate the chances of a March rate hike were pegged at 30 percent. After her two days of testimony that percentage had increased to 44 percent. But just as bond investors were unfazed by this adjusted stance last week, their equity counterparts welcomed it as good news. The S&P 500 added another 1.5 percent, cheered on by financial stocks with the XLF ETF climbing 2.9 percent, and by banks in particular as the BKX bank ETF surged by 3.4 percent.