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Don't dance to the bond-market blues
The stock market has been in a funk ever since the Federal Reserve met last week. The fear is that Greenspan & Co. are about to start raising interest rates. According to the bond market, those hikes could start as soon as May. I think the bond market is wrong.
By Jim Jubak
The worry goes like this: The Federal Reserve has cut short-term interest rates 11 times since January 2001 in an effort to get the economy growing again. But on March 19, central bankers decided no more stimulus was necessary and shifted to neutral. A move to neutral, the story goes, is a warning that rate hikes are on the way.
The bond market is certainly behaving like the Fed will raise rates later this spring. The short-term rates, which the fed most directly controls, have shown signs of moving up in the last week. The federal-funds futures market, a direct reflection of where investors think interest rates are headed in the future, is now calling for short-term rates to hit 3% by the end of the year -- well up from the Feds current 1.75% target.
The first hike of at least a quarter-percentage point will come as early as May, the tea leaves say. And theres a chance the move could be twice that, a half-point.
That would be bad news for the stock market. Higher bond yields would coax more money away from the stock market and into the bond market. Not exactly what investors, already worried that stocks are too expensive, want to think about.
But theres a good chance that the consensus worry is wrong -- or at least premature. And if thats the case, stocks might get a solid bounce when Greenspan and friends dont raise rates in May.
The case for disbelieving the bond market
The Federal Reserve typically drags its feet before shifting from cutting interest rates to raising them. A hike in May would be an unusually quick turnaround.
Thats especially true since the data on this economic recovery are so ambiguous. One example: Its true that the number new jobless claims fell last week, a signal of an economy on the mend. But the four-week trend, which is a more reliable indicator, actually showed an increase in claims.
The last thing Fed wants is to make a mistake and choke off a recovery thats just getting rolling.
Energy prices should help the Fed stand pat.
And the bankers have some extra margin for doing nothing right now. Energy prices have climbed recently -- oil futures have soared about 20% in the last two weeks, for example. And rising energy prices put a damper on the economy in much the same way that an interest-rate hike would.
Of course, rising energy prices are exactly the kind of evidence of potential inflation that leads the bond market to believe the fed will raise rates. But even here the bond market may have it wrong in the short run.
In recent speeches, Greenspan has indicated that hed actually welcome a little more inflation right now. That would give companies the ability to raise prices and increase their return on capital. And that would encourage companies to start investing in capital equipment again. A lack of capital spending, Greenspan has made clear, is the Achilles heel of the current recovery.
All this means that the bond market may have swung too far and too fast toward its belief in interest rate increases. Current economic conditions argue for rate increases in August or September instead of May.
Why is the delay of a few months important?
First, the delay creates the possibility of a spring surprise if the central bankers dont raise interest rates in May. That might give stocks a boost.
Second, and more important, every month of delay should supply increased evidence that the current recovery is for real. Corporate earnings, for example, should look much better in September than they do right now.
And if investors feel confident that the economy and corporate earnings are growing, theyre much more likely to shrug off an interest-rate hike or two. Rate hikes are, after all, just the normal price an economy has to pay for solid growth.
Even if the bond market has the timing wrong, I think the market has got the ultimate direction of rates right. Many Wall Street analysts are expecting the yield on 10-year treasuries to hit 6% by the end of 2002. Thats up from 5.4% now. I think thats likely whether or not the Fed acts to increase short-term rates.
After all, the yield on the 10-year Treasury has climbed from 4.3% in November without any help from the Federal Reserve.
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