The 5% Diet

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“The whole story is interest rate worries.”

Stephen Carl, head trader Williams Capital (subscription required)

“A lot of people are trying to come to grips with the idea that the Fed is just as likely at a future meeting, if not more likely, to raise rates rather than to cut them.”

– Stephen Sachs, director of trading Rydex Investments (quoted in E.S. Browning “Stocks Retreat as Prospects Of a Fed Rate Cut Grow Dim” (subscription required), The Wall Street Journal, Wednesday June 6)

The whole story of the stock market the last two days (and an important story for about two weeks now; see “Back To Obsessing About the Fed”, Thu May 24) is rising interest rates and a re-calibration of Fed expectations.

The yield on the 10 year treasury was up 6 basis points yesterday to 4.99% on a strong ISM services sector report and Bernanke’s speech in which he said that the economy looked strong and inflation risks were still to the upside.

Goldman Sachs also “ate crow” and rescinded their forecast for interest rate cuts this year.  They are now expecting the Fed to be on hold through the end of 2007.

Today, investors continued to digest Bernanke’s words as the European Central Bank hiked its target rate a quarter point to 4.0% and a report on unit labor costs came in stronger than expected. 

The Dow lost 130 points, on the heels of 81 yesterday, and the S&P 13.5 – on top of the 8 it lost yesterday.  That’s as bad a two day period as we’ve had since late March.

At the same time, the yield on the 10 year fell 2 basis points today to 4.97%.  There seems to be resistance at 5%.

One explanation for the up bond day (bond prices move inversely to their yields) and down stock day was given by Todd Clark, director of trading at Nollenberger Capital Partners: “It looks like you may be seeing the first wave of asset allocators selling equities and buying bonds.  Today is maybe the first wave of swapping” (subscription required). 

If this is right, this is bullish for the stock market.  It could be that bonds are starting to look attractive at these levels.  If people buy them here, that will support their price and cap the rise in interest rates.

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