In the cold days of early March, we forecast a "bumpy and rather noisy journey" into spring (See "The Song Remains the Same") that turned out to be well founded. The pullback in U.S. equities over the last two weeks is one of those bumps, but still, the NYSE Advance/Decline Line is in a strong upward channel, signaling that stocks could hit new highs over the next few months. Rising retail sales and increasing capacity utilization are evidence that the effect of severe winter weather is largely behind us and that the U.S. economy is on a sound footing. However, the likely negative effect of winter conditions on U.S. first quarter output make it unlikely that the 3 percent-plus GDP growth that many economists had forecast for 2014 will pan out. This may add to investor jitters following the recent equity sell-off.
Even with the improving outlook for the U.S. economy, gold has rallied recently and 10-year U.S. Treasury yields declined by 10 basis points last week, as the United States became a safe-haven amid anxiety abroad. Ukraine's descent into turmoil is increasingly worrying and is likely to become a bigger issue for investors. Markets are figuring out what unprecedented monetary action on the part of the European Central Bank might look like. In Asia, confidence in Japan's economy is waning after the sales tax increase there and nervousness persists over Chinese economic growth prospects.
Developments in Europe are particularly interesting. Once taboo phrases such as "quantitative easing" and "monetary stimulus" are now being openly used as ECB policymakers become increasingly concerned about the strength of the euro and the inflation outlook. One thing is certain -- additional liquidity from the ECB will have a major impact on the pricing of credit in Europe. The chart below suggests that the ECB has room to act.
All of this will weigh on the near-term outlook for U.S. interest rates. However, for now, the 2.6 percent yield on 10-year U.S. Treasuries will likely prove to be an area of support and a tough level to break below. While current market conditions may make investors uncomfortable, I remain largely optimistic and believe that one year from now, U.S. credit spreads will be tighter and U.S. stocks will be higher.
Taylor Rule Suggests ECB Should Ease Further
Core inflation in the eurozone was revised down to 0.7 percent on Wednesday, returning to December's all-time low. With disinflationary pressure mounting, and outright deflation an increasing possibility, the European Central Bank could soon move to ease policy further. Such a move would be justified by monetary policy rules such as the Taylor Rule, which currently shows the ECB's policy stance is too tight. With rates at just 0.25 percent, the ECB's easing would likely to be some form of quantitative easing.
ECB RATE AND TAYLOR RULE SUGGESTED RATE
Source: Bloomberg, Guggenheim Investments. Data as of 4/16/2014.
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