Tighter Credit May Not Squeeze Wall Street
Coming soon to the Economy Theater, a horror tale: “The Tightening, Part II.”
But will it be anywhere near as violent and bloody as the first one?
After another batch of healthy economic reports last week, many Wall Streeters are betting that the Federal Reserve Board will tighten credit again soon, for the second time in a month.
Brokerage CS First Boston in New York told clients Friday that the Fed could act as early as today by raising its discount rate from 3% to 3.5%. That rate, which banks pay for short-term loans from the Fed, hasn’t been increased since early 1989.
A discount-rate hike, after the Fed’s quarter-point boost in another key short-term interest rate on Feb. 4, would signify that the central bank is serious about restraining the economy and with it the potential for higher inflation.
But the Fed, as more often than not, finds itself in the difficult position of trying to orchestrate the economy without driving stock and bond markets to ruin.
And there has been plenty of ruin to go around in recent weeks, as Wall Street has responded to the Fed’s first tightening with a deeper sense of anguish than most pros had expected: Long-term bond yields have surged nearly a half-point since Feb. 4, while stocks have slumped.
Now, however, some experts believe the markets have factored in not only the first Fed rate boost, but the next one as well. That could mean that, if the Fed does act this week, stocks and bonds will respond either favorably to the news, or not at all.
Analysts point to the markets’ action on Friday, after the government reported a surprising drop in the nation’s unemployment rate, to 6.5% from 6.7% in January:
* Short-term Treasury bill yields jumped on the news, indicating that traders believe the Fed will seize on the strong employment report to boost rates again. Yields on 3-month T-bills shot up to 3.62% from 3.56% on Thursday.
The T-bill yield was 3.06% just before the Fed surprised markets with its first rate hike on Feb. 4. Because that initial hike was just a quarter-point, while the T-bill yield has since risen 0.56 points, it’s obvious that markets are assuming the Fed will do more, and soon.
* While short-term yields surged, long-term bond yields closed little changed on Friday after an initial rise. The 30-year T-bond yield closed at 6.83%, unchanged from Thursday after hitting 6.88% early in the day.
The reappearance of bond buyers, despite the February employment news, suggested that the market may be comfortable with long-term yields at current levels even if the Fed raises short-term rates further.
Indeed, the Fed has made clear that its No. 1 goal in tightening credit early is to quash inflation, which should in theory make the bond market happy because long-term interest rates are ultimately determined by the level of inflation.
* The stock market had a good day Friday, signaling that many investors are responding more to the promise of higher corporate profits in a healthy economy than to the risk posed by a gradual rise in short-term rates.
The Dow Jones industrials gained 7.88 points to 3,832.30 on Friday, and rising issues solidly outnumbered losers on the New York Stock Exchange and the Nasdaq Stock Market.
Perhaps most significant, the Nasdaq composite index of mostly smaller stocks leaped 5.97 points to 790.55 on Friday, and is now just 1.2% below its all-time high of 800.47 set on Jan. 31. The Dow, in contrast, is off 3.7% from its peak.
Some Wall Streeters say the surprising strength of smaller stocks in recent weeks may herald another rally in the aging bull market, despite the rising number of bears who believe that higher interest rates spell certain death for the bull.
“This is a fight between rising (corporate) earnings and fear of higher interest rates, and I think earnings will win,” says Louis Navellier, an Incline Village, Nev., money manager who runs $900 million for clients.
But can the bond market also win? Many pros are less sanguine about bonds’ longer-term prospects, even if the market sails through the next Fed hike. That’s because Fed Chairman Alan Greenspan and others may keep harping about the possibility of still-higher rates in the future, making it tough for bond investors to regain their composure.
“It’s difficult for the bond market to look through to the fundamentals of low inflation when so many Federal Reserve officials are talking about the next tightening,” says Lacy Hunt, chief U.S. economist for HSBC Holdings, a Hong Kong banking giant.
He believes that the Fed ought to lay low for now. Noting the surge in bond yields and the plunge in stock markets worldwide since Feb. 4, Hunt says, “I think the Fed has induced a considerable amount of restraint in the (economy)” just with its initial quarter-point interest rate hike.
Gary Schlossberg, economist at Wells Fargo Bank in San Francisco, also believes the Fed can afford to hold off, even though the market is already expecting another quarter-point rate increase.
Ironically, he says, the Fed may take its next cue from the bond market: If long-term yields continue to rise, suggesting that investors believe higher inflation is coming, the Fed may have to aggressively boost short rates to demonstrate its resolve to fight inflation.
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No Bonus For CDs: Though short-term interest rates are rising, you’ll be waiting a long time for bank and S&L; certificate of deposit yields to move up much, warns Bob Heady, publisher of Bank Rate Monitor. “Godot will show up sooner,” he jokes.
CD yields have barely budged despite the Fed’s quarter-point rate hike a month ago. The national average yield on 1-year CDs is now 3.14%, up from 3.08% immediately before the Fed move, according to Bank Rate Monitor.
“Banks pay what they can get away with,” Heady notes, and most banks simply don’t need more deposits today. Given the wide spread between U.S. Treasury security yields and CD yields, most savers in 6-month and 1-year CDs would be better off buying Treasury securities of those terms direct.
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SCEcorp Dividend Cut? Southern California Edison’s parent company is warning its 136,000 shareholders that their cash dividend may have to be cut, and Wall Street is acting as if it’s a done deal.
The electric utility’s holding company, SCEcorp, tells shareholders in the 1993 annual report now in the mail that its earnings are being squeezed as regulators lower its allowed rate of return.
In language clearly meant to raise a red flag, John E. Bryson, SCE’s chief, says in his shareholder letter that reduced returns “unavoidably . . . will affect our ability to raise or possibly even retain current dividend levels.”
Companies rarely spook shareholders with talk of a lower dividend unless chances are substantial that such a cut will occur. Electric utilities are particularly sensitive about their dividends because that payout, not share price appreciation, is the primary reason investors own the stocks.
On Wall Street, SCEcorp shares have plunged with other electric utilities since last fall. Much of that decline has been related to rising interest rates, which force utility shares down in order to force their dividend yields up, so that the stocks are competitive with bonds and other income investments.
But SCEcorp’s 29% stock slide, from $25.75 last fall to $18.25 now, has far exceeded the declines of most other utilities.
At the current price, SCEcorp’s annual dividend of $1.42 a share provides a yield of 7.8%--well above the yields of most other major utility stocks.
That return is so high, in fact, it’s a sign that Wall Street doesn’t believe it can continue. Many analysts believe investors have pushed the price down in anticipation of a dividend cut by SCEcorp, effectively valuing the stock based on some lower future dividend.
“I think it’s at least 50-50 that they’ll cut the dividend, and maybe a little stronger,” said Linda Byus, analyst at Duff & Phelps.
SCEcorp’s net earnings were $1.43 a share in 1993 after one-time charges, which means earnings barely covered the $1.42-a-share dividend. This year, Byus expects earnings to be no higher than $1.45 a share. Typically, utilities aim to pay out no more than 75% to 80% of their earnings in dividends.
Besides state regulators’ decision to lower what SCEcorp can earn in line with the long-term decline in interest rates in recent years (that’s how utility returns are set), the company has also suffered from the Southland economy’s recession and from lower-than-expected contributions from its Mission Energy independent power arm.
* ZAP FOR INVESTORS?
Is Southern California Edison planning a dividend cut? D4
CD Yields vs. Treasuries
Certificate of deposit rates at banks and S&Ls; have begun to creep up with the rise in short-term market interest rates. But if you have the wherewithal to buy U.S. Treasury securities direct, you can earn much higher yields than on CDs.
Maturity Bank CDs* Treasuries* Treasury yield Advantage 6-month 2.83% 3.86% +1.03 points 1-year 3.14% 4.27% +1.13 points 2 1/2-year 3.65% 5.08% +1.43 points 5-year 4.69% 5.81% +1.12 points
* Current annualized yields Bank CD yields are national averages. Source: Bank Rate Monitor
