Dividend stocks for income investors
See Jim's new portfolio to help navigate the treacherous interest-rate environment.
Jubak's Journal
Recent articles:
• 5 stocks ready for inflation's return, 4/19/2006
• Why metals stocks haven't peaked, 4/18/2006
• Oil patch is drowning in cash, 4/14/2006
More...
| | Jubak's Journal
Why interest rates will march higher
It's going to be tough in 2006 for stocks and bonds. U.S. long-term interest rates will keep climbing even if the Fed stops raising short-term rates in May. Here's why.
By Jim Jubak
Hold the euphoria, please.
The stock market's huge 195-point rally on April 18 would be a logical reaction to good news on interest rates from the U.S. Federal Reserve -- if the Fed really controlled long-term U.S. interest rates.
But the Fed doesn't. As the last two years have so clearly demonstrated, long-term U.S. interest rates are set in Japan, and China, and Saudi Arabia -- in any country that has a surplus of money to invest. They're not set in the good ol' U.S. of A., because we spend more than we save.
And logic says that the overseas investors who determine interest rates for five- and 10-year U.S. bonds will push those rates higher in the coming months. That will make for tougher sledding for most U.S. stocks and bonds in the rest of 2006.
Spark for a rally
Let's review what happened earlier in the week, shall we?
The Federal Reserve released the minutes from the March 27-28 meeting of the Federal Open Market Committee, the body that sets short-term interest rates in the United States. The minutes showed the committee was satisfied that inflation was under control: - Wage increases were modest;
- Housing price increases were showing signs of a slowdown;
- And energy prices hadn't yet led to price increases across the economy.
They worried that, although the economy was growing strongly, further interest-rate increases could go too far and tip the economy into a slowdown.
Related news and commentary on MSN Money
All in all, the members of the Open Market Committee seemed, in the financial markets' reading of the minutes, inclined to stop raising interest rates after one more hike at the May 10 meeting. "Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much," in the words of the minutes.
And on that -- plus a reading that morning from the Producer Price Index that confirmed the Open Market Committee's belief that inflation remained contained -- the stock market rallied. The Dow Jones Industrial Average ($INDU, news, msgs) climbed almost 200 points. The bond market was less enthusiastic but still moved in the same direction, with the yield on the 10-year Treasury note falling to 4.97%, down 3/100ths of a percentage point, as bond prices nudged higher. That move, small as it was, took the 10-year yield below the 5% level that it had breached on April 13. The yield on the 10-year Treasury note hadn't been above 5% in nearly four years.
The Greenspan conundrum
The market's upward move was a logical one. Higher interest rates put downward pressure on stock prices -- because companies have to pay more to raise capital, because higher interest rates slow the economy (and thus lower revenues and profits), and because the more bonds, CDs and other fixed-income investments pay, the more competition they pose to stocks for investors' cash. A promise from the Federal Reserve that interest rates are about to stop climbing, then, would be very good news for stocks.
Except for what has become known as the Greenspan conundrum. In the midst of raising short-term interest rates, former Fed Chairman Alan Greenspan confessed to his puzzlement about the curious behavior of long-term interest rates. Beginning in June 2004, the Federal Reserve raised short-term interest rates again and again from a low of 1%. But long-term rates -- the yield on the 10-year Treasury note -- refused to follow suit. In fact, the yield on the 10-year note fell from 4.7% in June 2004, when the Fed began to raise short-term rates, to a low of 3.95% on June 3, 2005. It climbed from that point, but it wasn't until March 24, 2006, that the yield on the 10-year note climbed back to where it had stood, at 4.7%, when the Federal Reserve started to raise interest rates.
That shouldn't have happened, Greenspan said. Investors normally want to be paid more when they tie up their money for longer periods, since the risks -- of inflation, a falling dollar, higher yields -- are greater the longer the time until maturity. Instead, investors in bonds were getting less in yield for taking on more time-risk. That became glaringly clear as the spread between the two-year and the 10-year note narrowed and then vanished. In March 2006, investors actually briefly got a higher yield -- 4.72% -- if they bought the two-year note than if they bought the theoretically riskier 10-year note, with its 4.69% yield.
The inverted yield curve
A lot of economists and bankers stayed up late at night in an effort to explain this condition, called an inverted yield curve. Economists noted that an inverted yield curve was often an indicator of a future recession. They also pointed out that the economy, while slowing, was still growing vigorously. Bankers said that maybe investors were giving the Federal Reserve, a group of bankers, a vote of confidence. The Fed hadn't just contained inflation but whipped it, and investors were betting that future inflation would be even lower than it was today.
But the markets continued to push up the price of oil, gold, and other commodities. That was hardly what you'd expect if these same investors believed that inflation was dead for the next 10 years.
|
