Stocks
Despite the fact that the market is now bracing for an interest rate hike at the end of the month, stocks continued to rally during the first two weeks of June. Positive corporate earnings news boosted investor sentiment, helping the S&P 500 to inch up 16 points, or +1.4% ahead of its May close.

Meanwhile, interest-rate-sensitive income-oriented stocks have been mixed over the past few weeks. After a 4-point spike on June 7th, real estate investment trusts closed down, with the benchmark Morgan Stanley REIT index 2.5 points off its May 28th close. Investors continued to park their money in defensive, non-cyclical stocks that are going to be less sensitive to changing rates. Many of these blue-chip companies also pay dividends, and as a result, the Dow Jones Select Dividend Index gained 4.2 points, up +1% for the first half of June.

Bonds
U.S. treasuries declined for two consecutive weeks early in the month on rumblings from Federal Reserve Chairman Alan Greenspan that he might accelerate the pace of future interest rate hikes in order to stem inflation. The Fed Chief warned that if inflation proceeds faster than expected, he “will do what is required to achieve price stability.” The implied yield on the July fed funds future contract shows that traders have already priced in a 100% chance that the Fed will lift its benchmark rate 25 basis points to 1.25% later this month.

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Yields on the benchmark 10-year treasury have climbed in the past two weeks to 4.8% as investors have fled fixed-income securities. From this year’s mid-March low of 3.65%, the benchmark yield has gained nearly +32% ahead of rising interest rates. Short-term issues, which tend to be much more sensitive to rate changes, posted even greater losses over the two-week period. Yields on the 3-month treasury surged +18.5% to 1.27% in response to expected interest rate changes. 

Outlook
Despite the challenges posed by higher interest rates, market research firm Standard & Poor's still believes its S&P 500 index will reach 1,215 by year-end. In addition, the group believes higher corporate profits will more than offset the effects of higher interest rates. Standard & Poor's predicts operating earnings of member stocks are likely to be up +19% this year. That forecast appears to be on target, as member companies have recently reported second-quarter profit gains of +19.9%.

The good news for income investors is that higher earnings typically translate into richer dividend payouts to shareholders. As interest rates rise, solid high-yield stocks should remain attractive. Unlike bonds, which lose value as yields rise, carefully selected blue-chip stocks offer both dividend income and the potential for capital appreciation.

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