US INTEREST RATES

Dec 10-year T-note prices climbed to a 1-month high, but still remain within a 3-point range bounded by a 6-1/4 month high and a 1-1/2 month low, both made last month. The 10-year T-note yield continues to fluctuate on either side of 3.50%, modestly below its recent 2-1/2 month high of 3.58%. Bullish factors for T-note prices centers on dovish Fed-speak from (1) Dallas Fed President Fisher who said "looking into 2010 and perhaps to 2011, the most likely outcome is for growth to be suboptimal, unemployment to remain a vexing problem and inflation to be subdued," which indicates that Fisher, a notable Fed hawk, may support keeping Fed policy extremely accommodative for an extended period, and (2) San Francisco Fed President Yellen who said that monetary policy must be kept “accommodative” to encourage job growth and keep inflation from declining further. Bearish factors include (1) the rally in the S&P 500 Index to a 13-month high which diminishes the safehaven allure of Treasuries, and (2) the larger-than-expected decline in the latest initial unemployment claims which fell to a 10-month low (-12,000 to 502,000 versus expectations of -2,000 to 510,000).

FOMC expectations—Market expectations for Fed policy were unchanged for the remainder of the year and were pushed back slightly for a tightening of monetary policy from mid-2010 and beyond. The market expects no significant chance of a Fed rate hike at the remainder of this year’s meetings. However, the  market is then expecting a slow rise in the funds rate to 0.50% by Sep 2010, to 1.00% by Jan 2011 and to 2.00% by Sep 2011.

US STOCK INDEXES

Stock prices sustained their 8-month rally as the S&P 500 index moved up to a 13-month high that represents a 48% correction of the 2-year plunge from the record high in Oct 2007 to March’s 13-year low. Bullish factors for stocks include (1) the +34,000 gain in temporary workers in the Oct payrolls report, the first gain since Dec 2007 and a possible harbinger of future increases in employment as payrolls at temporary agencies often turn up before total employment does, and (2) the prediction from former Fed Chairman Greenspan that a rebound in stocks is “re-liquefying” the US economy and housing prices are showing early indications of ending their decline. Bearish factors include (1) the warning from Moody’s Investors Service that banks are carrying more short-term debt on their balance sheets than at any time in at least 30 years and are vulnerable to sudden increases in interest rates or “swings in investor confidence” that could increase the cost of capital, and (2) the prediction from Baring Asset Management that companies that surpassed recent earnings forecasts mostly by laying off workers and shutting plants won’t be able to sustain those temporary gains.

Earnings expectations for the S&P 500 are as follows, according to Thomson Financial: Q3-2009 (-14.8%), Q4-2009 (+215.6%), Q1-2010 (+37.3%), Q2-2010 (+21.1%). S&P 500 annual earnings are expected at -7.4% in 2009 and +26.2% in 2010 (2008 -23.9%, 2007 -3.7%, 2006 +16.1%, 2005 +13.7%, 2004  +20.2%, 2003 +18.4%, vs 25-year average of +8.6%). The S&P 500 forward P/E (based on forward-looking earnings) is at 17.3, well above the 5-year average of 15.3.

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