What Happened in the Markets Last Week

There was a major sell-off in the markets last week. All of the major averages lost ground. The Dow was down 1.8%; the S&P was down 1.9%; the Nasdaq was down 1.5% and the Russell 2000 was down 2.1%.

The markets have rallied for the last three months and there were good reasons for the advance. There have been a ton of mergers thanks to abundantly available liquidity. Although second quarter earnings growth came in below 10% they were higher than anticipated, largely thanks to international sales. And while the markets aren't cheap by historical standards, they aren't expensive either. So the bulls had good reason to continue bidding up stocks.

However, there has also been some important bad news. April retail sales were terrible, although May's sales showed a bit of a rebound. The housing market shows no signs of recovery. The Bureau of Economic Analysis revised first quarter GDP down to .6% at the end of May. Yet none of these events seemed to do any damage to the bulls' position.

Until last week. Suddenly the markets were listening to Fed Chief Ben Bernanke when he made the following comment:

However, although core inflation seems likely to moderate gradually over time, the risks to this forecast remain to the upside. In particular, the continuing high rate of resource utilization suggests that the level of final demand may still be high relative to the underlying productive capacity of the economy.

Additionally, the European Central Bank raised interest rates on Wednesday from 3.75% to 4% citing a desire to contain upward price pressures. Suddenly there were two new words in everyone's vocabulary: inflation and interest rates.

For the last few months, the Federal Reserve has consistently stated inflation was their main concern. The markets simply refused to listen. Traders thought a slowing economy would lead to interest rate cuts to stimulate growth. Until last week, Fed Fund futures put the chance of a rate cut at 40%. This week traders suddenly listened to what Bernanke said and realized that interest rates may be increasing.

In addition, the 10-year Treasury's yield rose above 5% settling at 5.11% by Friday's close. 5% was an important psychological level for the market. When yields crossed above this level, the consensus was interest rates would continue to move higher, with an upward yield target of 5.25%. This would have ramifications throughout the economy as borrowing costs on everything from corporate bonds to mortgages would increase. Because the US economy is heavily dependent on credit, higher interest rates cause understandable concern.

So where do we stand now?

First, this week's sell-off wasn't that large by historical standards. As a comparison, after the China sell-off last February the S&P 500 (SPY) was down about 6%. Think of last week as the market blowing off the foam but not pouring out any beer.

According to the Bureau of Labor Statistics' latest report on inflation, the unadjusted 12-month increase in inflation for all goods and services was 2.6% and the core rate for the same period was 2.3%. This is hardly an excessive rate of inflation. However, the Federal Reserve has an unofficial core inflation target of 1%-2%. This means the core inflation rate is still above the Fed's overall comfort zone. Therefore, the Fed is more likely to raise rates than lower them.

Interest rates are an interesting situation. I have argued on my blog that 5% isn't a very high interest rate. Interest rates were over 6% during the later part of the 1990s and the economy still continued to grow at a healthy rate. However, a friend has argued the 10-year rate has been in an uptrend since 2003 and appears headed higher. This has ramifications for borrowing which is a vital component of the US economy. In addition, the US has added over $3 trillion dollars in net new federal debt over the last 6 years. An increase in interest rates could make this increased debt level a bigger problem at the federal level. This is an excellent point and deserves much consideration.

Finally, the market rebounded on Friday, indicating traders felt valuation levels were attractive for adding to new or existing positions.

So let's sum up what happened last week.

• Last week, the markets finally listened to the Federal Reserve's inflation concerns. Therefore...
• Traders sold-off their 10-year treasury positions. This...
• Lifted 10-year rates over 5%. Because credit is an important element of the US economy...
• Traders sold-stocks, ending a 3-month rally. But...
• The overall price decline is not large by historical standards, and...
• Traders bought stocks on Friday because valuation levels were attractive.

So, what will happen next week? We have three important inflation related announcements coming: import and export prices are on Wednesday, PPI is on Thursday and CPI is on Friday. Depending on how these numbers come in we could see a big sigh of relief or more selling. We'll have to wait for the numbers to see.