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Key Points for the Week

  • The Federal Reserve left rates unchanged and signaled tapering would likely begin later this year.
  • Existing and new home sales remain above the pre-COVID-19 trend and prices are strong, even though yearly comparisons are turning negative when compared to the housing surge late last year.
  • Concerns about a government shutdown, along with elections in Canada and Germany, are expected to have a minor effect on markets.

Central banks have a lot of influence on investors, markets and economies.

For the last year or so, the Federal Reserve has been purchasing $120 billion of bonds every month to ensure United States markets remained liquid and interest rates remained low during the pandemic. Last Wednesday, the Fed announced that it is ready to begin to buy fewer bonds, a process known as tapering. The Fed’s taper is expected to begin before year-end. The Fed is not expected to push interest rates higher for some time so, overall, monetary policy will continue to support economic growth.

On Thursday, the Bank of England (BoE) said it expects inflation to exceed 4 percent by the end of the year. That’s twice the BoE’s target inflation rate. After the statement was issued, one measure of investors’ expectations priced in “…a 90 percent chance that the BoE would raise rates by February [2022], up from just over 60 percent before – though some economists say this is premature given the challenges to growth,” reported David Milliken and Andy Bruce of Reuters.

Expectations that central bank policies will soon be less accommodating caused yields on 10-year government bonds in the United Kingdom and the United States to rise. “Surging long-term bond yields put an outsized dent into valuations for growth companies because those firms are valued on a relatively long-term basis,” reported Nicholas Jasinski, Jacob Sonenshine and Jack Denton of Barron’s.”

While rising yields can negatively affect equity valuations, they may not hurt share prices if company earnings continue to grow and investors’ appetite for equities remains strong, reported Sean Markowicz of Schroders.

Concerns about less accommodative monetary policy may be less pressing than worries about the health of China’s financial system. The People’s Bank of China injected cash into its banking system again last week to reassure investors after a large Chinese company missed a bond payment deadline, reported Anshuman Daga, Andrew Galbraith and Tom Westbrook of U.S. News & World Report.

This Week in the Markets

The Federal Reserve met last week, and Chair Jay Powell indicated tapering this year is more likely than not. The decision on when to reduce the central bank’s purchases of government-backed bonds will likely be affected by the employment report released a week from Friday. If labor market strength resumes, the Fed appears likely to roll back its support.

The biggest factor causing housing data to weaken is how strong it was last year. Existing home sales dropped 2% from the previous month and a similar amount compared to last year. New home sales have dipped 20% from last year. Even though sales have turned slightly negative, the number of existing home sales remains comfortably above pre-COVID levels.

The S&P 500 and MSCI ACWI both gained. The news from the Federal Reserve pressured bonds. The Bloomberg U.S. Aggregate Bond Index sagged slightly. Inflation will be the top focus this week as the PCE price deflator will provide additional perspective on how inflation pressures might affect markets.

Banned in China

China has been trying to limit cryptocurrencies for a long time without much success. In 2019, cryptocurrency trading was banned; however, the practice persisted. Earlier this year, the Chinese government restricted banks and payment companies from providing services related to cryptocurrency transactions and warned buyers they would have no protection if they traded cryptocurrencies, reported the BBC.

Last week, China banned all cryptocurrency transactions and announced that ten regulatory agencies will work together to enforce the ban, reported Alun John, Samuel Shen, and Tom Wilson of Reuters.

Cryptocurrency is “any form of currency that only exists digitally, that usually has no central issuing or regulating authority but instead uses a decentralized system to record transactions and manage the issuance of new units, and that relies on cryptography to prevent counterfeiting and fraudulent transactions,” according to Merriam Webster.

China also banned cryptocurrency mining. Unlike many types of money, cryptocurrency is not issued by a nation’s central bank. It is mined using an energy-intensive process that “relies on many distributed computers verifying and checking transactions on a giant shared ledger known as the blockchain,” reported the BBC. Prior to the ban, China was one of the world’s largest mining centers because of its relatively low energy costs and inexpensive computer hardware.

The ban doesn’t mean China won’t have digital currency. China’s central bank is developing an official digital currency that is being tested now and is expected to be introduced more widely next year.

The ban on crypto appears designed to build support for the official digital currency while signaling to Chinese residents that financial transactions must be traceable and won’t be tolerated on decentralized blockchains.

Daren Fonda and Joe Woelfel, Barron’s

The United States also is considering how to regulate cryptocurrencies.

Tapering Off

Last Wednesday, the Fed signaled it intends to announce the first reduction in the bond purchasing program related to the pandemic as early as the November FOMC meeting. Through this program, the Fed is buying around $120 billion per month to help stimulate the economy as it recovers from the pandemic. Some experts were expecting an announcement to come at last week’s meeting, but the combination of slowing growth from the rise of the Delta variant and data showing inflation is returning to normal levels pushed those expectations back.

At the same time, the Fed produced its expectations for growth and inflation over the next few years through the release of the Summary of Economic Projects (SEP). This report showed Fed officials adjusted their estimate for GDP growth this year down to 5.9% (from 7.0% in June) but increased their estimate to 3.8% for 2022 (3.3% previously). Essentially, they think the Delta variant will push some of the growth they anticipated for this year into next.

On inflation, Fed officials increased their PCE estimates for this year to 3.7%, while also increasing their expectations for 2022 and 2023. Chair Powell is sticking to his belief that current inflation is transitory but other events may cause more persistent inflation, such as extreme weather events.

The Fed’s plan may be complicated by timing of rate hikes in the future. Powell has been careful to “decouple” the tapering of the balance sheet and the timing of rate hikes over the past few months. He stressed that the U.S. is getting close to reaching targets for inflation and employment, which is why a reduction in bond buying is likely before year-end, but the thresholds for raising rates were stricter. What that means for the liftoff from zero remains to be seen, especially after this month’s more hawkish “dot plot” showed half of the members expecting at least one rate hike next year. For comparison, none of the FOMC members thought there would be a rate hike next year during the survey in March.

The debate around passing a government spending bill, which must be approved by Sept. 30, is drawing attention. The discussion will likely continue in October when Congress must decide whether to raise or suspend the debt ceiling. The House of Representatives approved a bill last week that would keep the government running, but it may prove difficult to pass the Senate.

It’s important to remember that debt ceiling increases are a natural outcome of spending to support the economy and are fairly common. The debt ceiling has been suspended or increased 78 times since the 1960s, regardless of which party is in power – 49 times under Republican presidents and 29 times under Democratic presidents. However, political posturing from both sides has also become part of the routine. Our expectation is a deal is reached at the last minute and the market impact is small.

Pending Tax Law Changes

The current debate over the Infrastructure Bills is not yet over and many of the proposed tax proposals may be amended or dropped before the Bill becomes final. Here are some of the tax changes being considered:

  • Increase the top income tax bracket to 39.6% (for taxpayers earning more than $400,000 ($450,000 on a joint return)
  • Increase the capital gains tax rate to 25%
  • Add a 3% surtax on those taxpayers making over $5,000,000
  • Tax unrealized capital gains at death (currently these gains are not taxed) for those decedents whose unrealized gains exceed $1,000,000.
  • Limit tax deferral though 1031 exchanges
  • Expand the Child Tax Credit and make it refundable
  • Creation of a vehicle mileage tax
  • Increased tobacco taxes

Did you Know? This Week in History

October 1, 1890: Yosemite National Park Established

On October 1, 1890, an act of Congress created Yosemite National Park, home of such natural wonders as Half Dome and the giant sequoia trees. Environmental trailblazer John Muir (1838-1914) and his colleagues campaigned for the congressional action, which was signed into law by President Benjamin Harrison and paved the way for generations of hikers, campers and nature lovers, along with countless “Don’t Feed the Bears” signs.

In 1889, John Muir discovered that the vast meadows surrounding Yosemite Valley, which lacked government protection, were being overrun and destroyed by domestic sheep grazing. Muir and Robert Underwood Johnson, a fellow environmentalist and influential magazine editor, lobbied for national park status for the large wilderness area around Yosemite Valley. On October 1 of the following year, Congress set aside over 1,500 square miles of land (about the size of Rhode Island) for what would become Yosemite National Park, America’s third national park. In 1906, the state-controlled Yosemite Valley and Mariposa Grove came under federal jurisdiction with the rest of the park.

Yosemite’s natural beauty was immortalized in the black-and-white landscape photographs of Ansel Adams (1902-1984), who at one point lived in the park and spent years photographing it. Today, over 3 million people get back to nature annually at Yosemite and check out such stunning landmarks as the 2,425-foot-high Yosemite Falls, one of the world’s tallest waterfalls; rock formations Half Dome and El Capitan, the largest granite monolith in the U.S.; and the three groves of giant sequoias, the world’s biggest trees.

Weekly Focus

A people that values its privileges above its principles soon loses both.

Dwight D. Eisenhower, 34th President of the United States

Many of life’s failures are people who did not realize how close they were to success when they gave up.

Thomas Edison, Inventor and Businessman