MARKETS : Investors’ Celebration Premature

Who could blame investors for celebrating last week?

After all, didn’t the latest statistics from the government show that inflation abated in April? And didn’t the recent Treasury refinancing, in which the government replenished its coffers by $30.5 billion, go off without a hitch? And aren’t Congress and the President at this very moment beginning a powwow that will undoubtably solve that dastardly problem with the federal budget deficit?

What wonderful developments those are.

And if you happen to dislike stocks, put your money into bonds. Who wouldn’t be happy to accept yields of more than 8.6% on long-term bonds? Boy, oh, boy! This sure is a great time to be an investor. You can’t lose.

Now that we’ve gotten that out of our system, let’s douse that enthusiasm with a little reality.

Interest rates seem to have come down (and bond prices gone up) because the economy is in trouble. Retail sales, employment levels and industrial production were all much weaker than experts had predicted.

As the bond market sees it, the economic slowdown means that the Federal Reserve Board will have to reduce interest rates.

That same weak economy is probably behind the sudden decision by President Bush to try to arrive at a compromise with Congress on the federal deficit. With the nation’s economy apparently sagging, the government’s revenue shortfall will make the budget deficit look yucky.

All that, of course, is good news for bonds. If permanently lower interest rates should come out of all this--and that’s a big “if” because of upward pressure on rates overseas--the value of bonds held by investors will appreciate.

But does that mean that slower economic growth is good for stocks?

“If interest rates are coming down because we have moderate growth and low inflation, then the stock market has a right to rally,” says David Jones, chief economist of Aubrey G. Lanston & Co., a government bond dealer. Jones is also one of the most respected Fed watchers in the investment community.

“But if interest rates are coming down because there is (economic) trouble ahead, then the stock market had better watch out,” he says.

Jones thinks that interest rates are falling because of the second reason: trouble with the economy.

A chief reason that the federal government is coming up short in its revenue forecasts is that individual taxpayers and corporations aren’t making as much money as expected.

Why, then, would the stock of corporations react favorably to such apparent bad news?

Says Jones: “In the past, the stock market has applauded slower economic growth and stable inflation because it meant lower interest rates, which in turn would make stocks more attractive when compared to bonds.

“But this is an entirely different situation. When slower growth in the economy could exacerbate already weak (corporate) earnings, as well as create credit problems, then the outcome for stock prices should be negative instead of positive.”

As you know by now, the cheering began when the government announced that producer prices dropped 0.3% during April. Last week the government disclosed that the more important consumer price index, which includes the costs of services, rose 0.2%. That’s about what most economists had expected.

Let’s give the data the benefit of the doubt and say inflation is moderating. Does that mean that the Fed will lower interest rates soon?

William V. Sullivan, senior vice president and economist at Dean Witter Reynolds Inc., says the central bank will move hesitantly on interest rates.

The Fed, says Sullivan, “won’t be that quick” to lower rates. “It will probably be a period of several months before we see the active reduction of interest rates.”

The Fed is still very concerned about the so-called core rate of inflation, and it won’t abandon its inflation-fighting high interest rate policy just because one month’s economic statistics were sluggish.

Even if the Fed decides to reduce interest rates, there is a big question as to whether that policy will stick in the marketplace. Interest rates overseas have been climbing the past few months and there is no sign of a major reversal.

“If the Fed were to ease interest rates now, I believe the dollar would collapse. That would be followed by the bond market collapsing and that would put an enormous amount of pressure on the stock market,” says Charles F. Eaton, a longtime Wall Street economist who now co-heads Intervest Securities Inc.

Eaton says that, after factoring out inflation, U.S. interest rates are already 2 1/2 percentage points lower than rates in any of the major nations with which the United States trades. A drop in interest rates here, without an accompanying drop in rates overseas, could be disastrous, sending foreign investors scurrying out of U.S. financial markets. While foreigners aren’t abandoning U.S. financial markets, they aren’t heartily embracing them, either.

Experts say demand for what the Treasury was selling was strong at the May auction. But, they add, a lot of the buying--especially in the longer maturities--appeared to have been speculative purchases made by U.S. dealers.

Those dealers were banking on their ability to unload the bonds on small investors, to whom the 8.83% yields on the 30-year bonds should be very attractive. The all-important Japanese demand for the bonds wasn’t any better, or worse, than it usually is.

But keep in mind what went on last week during the bond auction. Out of the blue, Congress and the President suddenly announced their budget negotiations. And, maybe more important, newspapers were reporting that President Bush was willing to back off his stand that the budget gap would not be filled by new taxes.

With that as a backdrop, there was every reason to believe that the Treasury refinancing would be enormously successful.

Things looked a little different right after the refinancing. First, there was some talk from White House officials that President Bush really wouldn’t accept any new taxes. (That issue is still up in the air.) And then White House press secretary Marlin Fitzwater said the budget talks could take weeks--maybe even months--to conclude.

In short, it looks as though Washington is getting back to politics as usual.

With all of this economic and political uncertainty, there is a lot of room for disappointing news to come out in the weeks ahead. And the financial markets are likely to react very negatively to any disappointment.