It was a great week for the equity market. That is how venerable CNBC reporter Bob Pisani summed up the past week and he was right. It was a great week.
The S&P 500 increased 3.0%, yet that left it looking up at the Nasdaq Composite and Russell 2000, which gained 3.5% and 3.1%, respectively. For good measure, the S&P 500 reached a new, all-time closing high, as did the Dow Jones Industrial Average, S&P 400 Midcap Index, and Russell 2000.
The stellar performances will undoubtedly be attributed to a sense of relief among market participants that Fed Chairman Bernanke made it sound like a tapering of the Fed's asset purchases may not be occurring as soon as some had feared (i.e., September) and that, even if a tapering were to occur, the market can still rely on very accommodative monetary policy. Bernanke's signaling in that respect will be traced back to four conciliatory soundbites:
- Both sides of our mandate are saying we need to be more accommodative
- If the economy is hobbled by interest rates going up in anticipation of the Fed's actions, "we'll have to push back against that"
- The 7.6% unemployment rate probably understates the weakness of the labor market
- Highly accommodative monetary policy for the foreseeable future is what's needed in the US economy
What might get lost in the summary translation is that the major averages were already doing quite well for the week, even before the Fed chairman said an official word after the close on Wednesday. To that point, the S&P 500 was up 1.3% through Wednesday after recording a 1.6% gain in the prior week.
Icing on the Cake
The pre-Bernanke advance was noteworthy in that it transpired with the IMF cutting its 2013 economic outlook for the world (to 3.1% from 3.3%) and the US (to 1.7% from 1.9%), oil prices topping $106/bbl on geopolitical and supply concerns, and China reporting a surprising decline in both its exports (-3.1%) and imports (-0.7%) for June.
The prior week's gain, meanwhile, came on the back of a stronger-than-expected June employment report that left the market thinking a tapering would be occurring sooner rather than later. In the wake of that report, the yield on the 10-yr Treasury note kissed 2.75%. The interesting thing is that the stock market rallied despite the jump in long-term interest rates.
The spin at the time was that the 195,000 increase in nonfarm payrolls was a sign of a strengthening economy, and that stock market participants were encouraged by that because it bodes well for corporate profits. Nothing wrong with that, except the Fed chairman now tells us that labor market conditions may not be as good as they appeared in that report.
The irony is that the stock market rallied after that admission, too. In a certain sense then, one could say the stock market had its cake and its regurgitated cake, too.
Keeping the Faith
One very important takeaway from the past few weeks, though, is that the stock market still has faith in the Fed. How do we know?
First, it calmed down when a number of Fed officials came out after the June 19 press conference to indicate that the stock and bond markets overreacted to what the Fed chairman said in laying out a tapering timeline. To wit, the post-FOMC sell-off hit a low on June 24 and the S&P 500 has been rising ever since.
Secondly, the stock market rebound effort has come in the face of higher interest rates, implying that there is faith in the view that the Fed's policies are helping, and will continue to help, boost economic growth. That view will soon be put to the test, though, as the consensus second quarter GDP forecast is close to 1.0% (our forecast for Q2 GDP is -0.3%).
Third -- and this perhaps matters most -- is that the stock market still responded strongly to what the Fed chairman said. That was true when it sold off after the June 19 press conference and it was true when Fed Chairman Bernanke offered the remarks highlighted above. The strong response on both occasions suggests the stock market still finds the Fed chairman's views credible.
The Treasury market, though, seems less convinced that the Fed is going to hold off on tapering past September. The 10-yr note yield has come in just eight basis points to 2.60% since the "Great Moderation" by Fed Chairman Bernanke. That is still 40 basis points above where the yield was on June 18.
The slowness with which yields have come down could also be a reflection of the belief that the resilience of the equity market is apt to drive a rotation out of bonds and into stocks. In that sense then, the stubbornness of the bond market could also be interpreted as an indication that participants believe growth is going to accelerate in coming months.
What It All Means
The week ahead isn't going to bring any reprieve from the market's obsession over the path of monetary policy.
The earnings reporting season will be kicking into high gear, China will have released its second quarter GDP report, gas prices are certain to be higher, and, fittingly, Fed Chairman Bernanke will be giving his semi-annual testimony on monetary policy before the House Financial Services and Senate Banking Committees on Wednesday and Thursday, respectively.
We expect the Fed chairman will be asked to explain further why he thinks the 7.6% unemployment rate is probably understating the weakness of the labor market and whether the Fed could possibly still take a step down in its asset purchases by Labor Day.
It will be an eventful week to say the least, and the potential is ripe for it to be a confusing week. In considering the past few weeks, though, it is abundantly clear that the stock market is having its policy cake and eating it, too.