Fed could be a surprise catalyst for markets in holiday week

Market Trading EssentialsJuly 2, 2021

5 minutes read

Traders on the floor of the New York Stock Exchange.

Source: NYSE

The quiet holiday week ahead could hold some fireworks for investors if the Fed reveals its thinking on its bond buying program.

The four-day trading week could see stocks drift along with indexes at record levels, after stocks gained in the past week. The closely watched 10-year Treasury yield held under 1.5%, a positive for tech which outperformed with a more than 2.9% gain for the week.

There are very few economic reports of note, aside from ISM services data on Tuesday. But the Fed’s minutes from its last meeting will be released Wednesday afternoon, and there is potential for the market to learn more about the central bank’s behind-the-scenes discussions on winding down its quantitative easing program.

“Our base case is that rates drift higher, but in order to that get that move higher you need a catalyst to get there,” said Brian Daingerfield, head of G10 FX strategy Americas, U.S. strategy at NatWest Markets. “Either the Fed has to move forward aggressively on tapering, or you have to get the data really rocking, and you don’t have either.”

Friday’s report that 850,000 jobs were added in June was better than expected, but the unemployment rate’s rise by 0.1 percentage points to 5.9% instead of falling to 5.6% as expected was disappointing. The report was not seen as strong enough to encourage the Fed to step away sooner from its easy policies, but it was seen as a positive, though largely incomplete, picture of the labor market.

Daingerfield said there is the potential for the Fed’s June meeting minutes to surprise the market, similar to the way April meeting minutes did.

“Remember, Powell said they were not talking about talking about tapering,” he said, referring to Fed Chairman Jerome Powell’s comments right after the April meeting. “Remember, Powell was very dismissive, and then the minutes revealed a kind of drift to the committee.”

The April meeting minutes did surprise investors when they noted that “a number of participants” said it would be appropriate to begin discussing tapering bond purchases at upcoming meetings if the economy continues to make rapid progress. Then after the June meeting, Powell revealed early stage discussions about paring back bond buying, and the Fed also presented a new forecast that included two rate hikes in 2023, where there were none indicated before.

The market is highly sensitive to details about the Fed bond purchase program since once the central bank ends that program, the door would be open for it to raise interest rates. The low-rate environment has been the kindling behind the stock market’s robust gains since the Fed went all out to help the economy get through the pandemic. Cutting back on the $120 billion bond purchases would be the first easing up of those extraordinary measures.

“There’s a lot we don’t know about the Fed’s thinking about tapering,” said Daingerfield. He said key information would be when it plans to start, how rapidly it will move to wind down the program and how it decides to break down its current monthly purchases of $80 billion Treasurys and $40 billion of mortgage securities.

“These details really do matter. Did they get into that conversation at all about details? The more detail they discussed, the more likely it is they are looking to move forward sooner,” Daingerfield said. Fed watchers widely expect more details about tapering the bond program around its annual symposium in Jackson Hole, Wyo. in late August, and then start slowing purchases later this year or early next year.

For now, the positive tone in the bond market has helped stocks. The 10-year yield, which moves opposite price, has fallen from its high of the year of about 1.75%. At that level, technology and growth shares were under pressure.

But they’ve been making a comeback as rates drift around in a range below 1.6%. The 10-year was at 1.43% Friday, and while the lower rate may help tech stocks, the yield level is a sharp contrast to an economy that was expected to grow at more than 10% in the second quarter.

That pace is expected to slow, but growth for the year is expected to be robust at more than 7%.

Tech transition

Steven Wieting, chief investment strategist and chief economist at Citi Global Wealth Investments, said with the economy peaking, the time is right for investors to begin a transition to tech and growth shares from the popular cyclical trade.

“We’re seeing this as all a temporary period of massive distortions, and within a year from now, we’ll be on steadier water,” he said. “I think this is giving people a reason, including us, to move away from just cyclical rebound trades and into some sustainable growth opportunities.”

Year-to-date, cyclicals have been some of the better performers. Energy shares are up 44% with the rebound in oil prices, and financials have bounced by nearly 25%. By comparison, S&P 500 growth stocks are up 14.4%, lagging slightly the S&P 500’s 15.5% gain. Tech stocks are up just 14.3% year-to-date.

One area Wieting now likes is global health care. The S&P health care sector was up 12.5% for the year so far.

“Health care is a mid-cycle outperformer. Health care is a part of the economy that didn’t fall as hard,” he said. “Earnings and revenues have grown moderately every year since the mid-1980s.” He said the sector has lagged the S&P 500 since the end of 2019 by 10 percentage points, and has a cheap valuation. Big pharma stocks are among the best dividend payers.

For the major sectors, on a 12-month basis, the cyclical sectors of industrials, materials, and energy have all risen more than 40%, and tech has had a similar 42% gain.

“The growth stocks have stayed rich. The value stocks have completely caught up with growth stocks in 12-month performance, but the valuation hasn’t been beaten down in growth stocks,” he said. “Gradually we’re going to get more sustained performance out of tech after this period where it flatlined.”

Wieting said one area that is particularly attractive is cyber security, where demand is strong as a “tech spending essential,” but the sector has gone nowhere.

For instance, the iShares Cybersecurity and Tech ETF IHAK is just below its 52 week high set in January, and the Global X Cybersecurity ETF BUG is trading about a dollar below its February high.

Wieting said he likes some alternative energy names and companies that are involved in digitization, including fintech.

He expects the overall stock market to move higher but not at the same rapid clip.

“We want to start transitioning portfolios away from just rebound plays … We’re transitioning knowing we’ve captured significant outperformance over the past year with cyclical value. It made people comfortable investing in equities when we could show how cheap they were,” he said.