All year we’ve heard numerous pundits citing high oil prices as a main reason for the market’s year-to-date losses. However, after seeing oil spike from the mid $40’s per barrel up to nearly $57, along with a stock market that is holding up very well, we can see that oil has not been the primary driver of stock prices, up or down.
Instead, it’s all about interest rates. Speculation of the Fed stopping at 3.5% Fed Funds, coupled with tame inflation data recently, has more than made up for higher energy prices in the minds of investors. This is not to say oil prices are completely irrelevent, but rather to imply that if the market gets everything else it is looking for, $60 oil most likely will not hold back equity prices in a meaningful way.
So, where are interest rates headed? You may have noticed that in a relatively short period of time the consensus view has shifted from “Greenspan always overdoes it and will take rates too high which will slow the economy” to the current view that “Inflation is low and Greenspan doesn’t want to overdo it again so he’ll stop after 1 or 2 more hikes, taking Fed Funds to 3.25% or 3.5%.”
The consensus on the 10-year bond has also shifted from “It’s just a matter of time before we see 5%” to “We could stay under 4% for a very long time.” Bill Gross of PIMCO has even said publicly that he sees the 10-year going to 3% in the next couple of years.
While I certainly think we could see the rate hikes come to a halt at 3.25% or 3.5%, and would welcome such a development from an investor standpoint, I’m not as convinced as most are that this will occur. I still think there is a good chance we’ll get to 4% Fed Funds, with the 10-year bond around 4.5%.
If this happens, the market will have to once again adjust expectations and we could give back some of the recent gains. I have been playing this thesis by trimming some equities during this run-up, along with shorting the 10-year bond under 4%.