Pressure in the bond market could set the market mood for June

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The S&P500 closed even lower last week, but as we mentioned last tuesdaydon’t be surprised to see additional volatility in the market over the next few weeks.

Frankly, we are surprised that the market has been so quiet. Although it didn’t get much press, the Fed kicked off its quantitative tightening (QT) campaign last Wednesday, which will likely continue this week as well.

Currently, the Fed holds almost $9 trillion in Treasury, corporate and mortgage bonds. They did this to try to stimulate the economy and have been building this portfolio since 2008 when Ben Bernanke was president.

The Fed can only reduce its stake by selling bonds. According to the “laws” of supply and demand, assuming everything else stays the same, if you increase the supply of bonds, the price of the bonds will fall. We believe this will make for another difficult year for bond investors. Also, when bond prices go down, long-term interest rates go up… which is bad for everyone.

The Fed board said it would try to sell $95 billion in bonds each month. However, in our experience, what the Fed says it will do and what will happen are two different things. If the sell off disrupts the market too much, it will slow down, but things will be tough in the meantime.

It may sound dire, but it’s not all bad news right now.

Retail and labor reports were very strong last week, but these are more likely to hold a bottom under stock prices than send the market higher. In our view, it will take confirmation that inflation is starting to ebb for prices to start slowly climbing back to previous highs.

June is always a bit dry for new economic or earnings data. However, there are a few announcements to watch out for that could help bolster our confidence that we are not going to see new lows in the market this summer…

Every Wednesday, the Energy Information Administration releases its Petroleum Inventory Number. It is a measure of the evolution of the number of barrels of oil held by the industry. It’s not a report that traders typically pay much attention to, but it’s an unusual market, and it’s really important right now.

What investors would like to see is an increase in stocks. This means that companies have overestimated energy demand. It sounds bad, but right now it’s a good thing. If companies stockpile more oil inventory, prices should drop a bit as companies use up their inventory or sell it.

Energy prices have risen to their highest since mid-April. We’ve even seen reports of gas prices at the pump approaching $10 a gallon in California. Energy costs are a major source of inflation; the more consumers pay to fill their vehicles and to travel, the less they spend on other consumption, which is bad for stocks.

Another report on consumer price index (CPI) inflation will be released by the Bureau of Labor Statistics. Currently, economists expect annualized inflation in the range of 8.8 to 9%. If inflation meets or exceeds these expectations, we believe traders will have a very negative reaction, which could drive the market lower towards the weekend.

The Federal Reserve is meeting next week to announce the next round of rate hikes. There has been a recent improvement in inflation measures lately, but we fear Friday’s numbers were pushed much higher due to rising energy costs.

what you should do

We recommended that investors focus now on large-cap value stocks and consumer staples. Last week, we extended this to semiconductor stocks for investors willing to tolerate a bit of risk. Although our outlook for this week is cautious, we maintain this position.

Energy also still looks good, and we still believe that large natural gas producers are the most likely to benefit long-term portfolios. However, oil companies and refiners are currently overbought and have more downside risk than short-term upside potential.

Conclusion

There isn’t much news this week until Friday when the next inflation report comes out. This may help keep volatility a bit lower, but we don’t expect to see a big upside move. For now, investors are still waiting for evidence that inflation has come down enough for the Fed to dampen faster interest rate hikes before sending stocks much higher, and we don’t think that evidence will appear this week.

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