James Hyerczyk
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Jerome Powell

U.S. equity indexes continue to climb early Tuesday. Underpinning the markets are near historically low interest rates and corporate earnings growth. Yes, despite seven gradual rate hikes since December 2015, interest rates are low and that is driving investors into stocks because they are still the best investment.

Looking at the market’s performance this year, we can see that stock market investors aren’t afraid of a 10-year Treasury yield at 3 percent. Therefore, yields are going to have to go a lot higher to encourage investors to cut allocations in stock for better yields in Treasurys.

Given Fed Chair Powell’s comments on Friday, it looks like rates are nearly neutral by the central bank’s standards so the 10-year is not likely to rise much above 3 percent next year. This is even better news for stock investors.

Analysts agree that yesterday’s announcement of the U.S. trade deal with Mexico combined with the previously mentioned factors helped trigger the surge in stock prices on Monday. Some also claim that the markets are merely capturing gains that they could have had earlier in the year, had there not been tariffs placed on Mexico in the first place.

They are also saying that the trade dispute with China is helping to limit the stock market’s gains. I’m having a hard time calculating how much business has been lost due to the trade disputes with China and Europe as well as their impact on the stock market. I’ve always thought that the markets discount future events. So where we are today reflects the impact of the trade disputes. Therefore, I have to conclude that once these limitations are lifted, this market is in for one great ride.

Powell May Have Inadvertently Put Stocks Back Inside the Bubble

The July Fed minutes released last week showed that Fed officials indicated that valuations of stocks and other assets are “elevated” while corporate borrowing conditions are “easy.” This was as of July 31 – August 1.

Since then stocks have gone on a tear and Treasury yields have fallen. If stocks were “elevated” at the beginning of August then what are they now? “More elevated?” And who helped fuel this current surge, Mr. Powell. Unfortunately, we’re going to have to wait until last September to see if policymakers have raised their concerns over stock market valuations.

Furthermore, if yields are dipping then this could only make borrowing more attractive to corporations. So their borrowing rate may rise as a result.

I’m not sure that Powell anticipated this result when his tone suggested the Fed was coming closer to neutrality. My only fear as a bubble-watcher is Powell and the Policymakers change their tune later and encourage more aggressive rate hikes. This could create uncertainty over policy and threaten to pierce the investment bubble.

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S&P 500 Index and Dow Recovery Rallies

Earlier in the year in late January and early February the S&P 500 Index and Dow reached their highs for the year. At that time, a change in the number of potential rate hikes by the Fed from 2 to 3 to 4 helped drive the volatility that fueled the plunge in prices.

Last week, the S&P 500 Index recovered all of its earlier loss and is currently setting another record high this morning. The Dow still has room to rally before it makes a new record high.

So I think it’s safe to say that investors have absorbed the first two rates hikes and are showing signs that they have priced in the next two. Given the previous reaction to the news of additional rate hikes, it seems to me that if the Fed thinks we are in a potential bubble situation then the only way they can prevent “irrational exuberance” is to get more aggressive with rate hikes. This will definitely be a rally killer.

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