Investors encountered an interesting week across financial markets as both the U.S. dollar and S&P 500 reached new 2010 highs, stocks later reversed on elevated volume, and Treasuries were bloodied in the wake of tepid auction demand. Economic news was mixed: durable goods orders showed continued strength in the economy, while existing and new home sales suggested that housing remains vulnerable to extended weakness. In addition, members of the European Union and the International Monetary Fund reached agreement on a framework for the potential bailout of Greece, and a South Korean naval ship sunk in the Yellow Sea, possibly the victim of a North Korean torpedo. And one other major piece news…the $1 trillion health care legislation was signed into law.

With so much occurring in a short period of time, market observers struggled to attribute the week’s moves in the markets. A couple of major points seem clear, however. First, equity markets continue to show amazing resilience in the face of significant worries. Second, interest rates seem poised to increase as the U.S. Treasury finds it difficult to finance the huge budget deficit.

Why are equity markets performing so well despite the risks? One reason is that corporate cash flow and earnings are impressive, potentially providing the fuel for continued economic growth as fiscal and monetary stimulus begins to wane. Another is that many investors missed much of the rally, are currently overweight fixed income securities, and are chasing stocks higher. Where this ends is anyone’s guess, but a significant rotation out of bonds and into stocks would drive the markets significantly higher.

As for interest rates, both the passage of health care legislation and tepid demand for Treasuries this week add to concerns over how the market will absorb record Treasury issuance. Although the Congressional Budget Office stated that the health care bill will actually reduce the deficit, credible market analysts beg to differ, and that’s all that matters today. The chart below shows that the Treasury faces difficulty in finding enough buyers for billions in new debt, and rates will need to rise to attract those buyers. This week’s rise in rates is only the beginning.

Wild Week


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