TSP

The market is expecting the Fed to ease interest rates to help stimulate the slowing economy. While that could be interpreted as bad news, the valuations of many assets are inversely correlated with interest rates.

Lyn Alden

Last week was bullish for a surprising number of different markets. The S&P 500, which the C Fund tracks, reached new all-time highs:

Chart Source: Google Finance

The Bloomberg Barclays Aggregate Bond index, which the F Fund tracks, continued to highs not seen since 2016, and to all-time highs if interest is reinvested, which the F Fund does:

Chart Source: Google Finance

Even the price of gold spiked to a 6-year high and hit $1,400 per ounce:

Chart Source: Google Finance

It was a strong week for many other commodities as well. The price of WTI oil went up 10% due to concerns about aggression between the U.S. and Iran, copper and silver prices moved up, and several agricultural commodities such as corn, wheat, and soybeans spiked higher.

The S Fund is still below its highs set in September 2018, and the I Fund is still below its highs set in January 2018. These funds participated in last week’s broad bull market, but continue to lag overall.

Pending Interest Rate Cut?

The key driver for many of these bullish moves came from the U.S. Federal Reserve on Wednesday. Every 6 weeks, the Federal Open Market Committee gives an update of its interest rate policy, and their comments this time were interpreted as dovish by the market.

The bond market is driving interest yields down in anticipation of an economic slowdown and is now pricing in a 100% chance that the Fed will mildly cut interest rates during the next meeting in July. The 10-year Treasury bond briefly dipped to a 1.99% annual interest rate, which is a low level that has not been seen in several years. It has since recovered slightly to above 2%.

The G Fund interest rate tends to be very close to the 10-year Treasury bond yield. I wrote a few weeks ago how these shrinking interest rates are negatively impacting the G Fund interest rate, and you can read that article here: Why the G Fund Interest Rate is Shrinking

When Bad News is Good News

The market is expecting the Fed to ease interest rates to help stimulate the slowing economy. It could be interpreted as bad news that this type of action would be necessary.

However, the valuations of many financial assets are inversely correlated with interest rates. When inflation-adjusted interest rates on safe government bonds are high, all else being equal it drives down the valuations of stocks, real estate, gold, and other assets. In contrast, when inflation-adjusted interest rates are low, it can boost the valuations of these assets.

The idea that the Fed may cut rates to support the economy is potentially a bearish indicator over the next year or two. However, in the shorter-term, the market is re-pricing many assets at a higher level as interest rates have declined.

The best case that the market is hoping for here is for the U.S. economy to slow down a bit, but not head into a recession any time soon, for the Fed to trim interest rates, and for those lower interest rates to help support high asset prices for a while longer. If that comes to pass, we could see decent gains in stocks and other risk assets. However, if the economic slowdown continues to unfold without reversing, it could put stocks at considerable risk of a sell-off.