IMPACT OF THE FED RATE INCREASE / THE VIEW FROM WALL STREET : Wall Street Takes Heart; Dow Soars 49 on Move

The Federal Reserve Board gave investors what they wanted on Tuesday: A hefty interest-rate hike, and--more important--the promise that that’s all for now.

The Fed’s half-point boost in its two key short-term rates sparked an immediate rally when the news hit Wall Street at 2:30 p.m. EDT, and the buying continued til the close.

The Dow Jones industrial average jumped 49.11 points to 3,720.61, its highest finish in seven weeks. In the bond market, the bellwether 30-year Treasury bond yield tumbled to a two-week low of 7.26% from 7.44% Monday.

Investors don’t normally root for higher short-term interest rates, of course, but the economy’s healthy pace this year has fanned an unexpected--and some say ridiculous--inflation paranoia on Wall Street.

With each bullish economic report in recent months, long-term interest rates surged and stock prices crumbled, on fears that faster growth would inevitably mean higher inflation. Though the Fed began to tighten credit in February in an attempt to slow the economy, the markets didn’t believe the central bank was moving fast enough to make a difference.

Indeed, each of the Fed’s three quarter-point increases in short-term rates, prior to Tuesday’s half-point rise, simply added to financial markets’ woes by focusing investors on the likelihood of another increase down the pike. The Fed was accused of dallying.

By last week, the markets had all but backed the central bank into a corner: If Chairman Alan Greenspan and the other Fed governors cared at all about investors’ view of the economy and inflation, the Fed would have to engineer a half a point rate rise at its policy-setting meeting this week.

And so, Greenspan came through. Usually, Wall Street sells rather than buys when its expectations are met. But this time, many pros say, investors’ relief that the Fed is moving aggressively to moderate economic growth overwhelmed the sell-on-the-news crowd.

“If the question was whether the Fed was behind the curve, this has to tilt peoples’ opinion toward the notion that the Fed has at least caught up with the curve,” said Steven Nothern, who manages bond mutual funds for Massachusetts Financial Services in Boston.

Thus, the inflation worrywarts could feel better Tuesday. But more significant was the bone the Fed threw to investors whose greatest fear was that another round of rate hikes would soon follow this one. The Fed essentially said it is done for now, having wrung out the “monetary accommodation” that had helped goose the economy over the past nine months.

“They’re communicating that policy is apt to be on hold for a reasonable period of time,” said William Sullivan, money market economist at brokerage Dean Witter Reynolds in New York.

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For Dean Witter, that suggestion of stable short-term interest rates in the near term was enough to warrant a bullish turn toward bonds, on the expectation that long-term rates now have room to fall back after rocketing in recent months.

Dean Witter recommended Tuesday that clients increase their bond holdings to 35% of their portfolios from 25%, while cutting short-term “cash” investments from 25% to 15%. Stocks’ recommended weighting was left at 50%.

Patrick Retzer, manager of the Heartland U.S. Government bond fund in Milwaukee, also believes that the bond market is ready to rally. He snapped up longer-term bonds on Monday, and also removed a hedge from his portfolio, effectively lengthening the average maturity of the fund’s bonds. Given Tuesday’s plunge in long-term yields, Retzer’s strategy of locking in high yields worked beautifully: His fund’s share price jumped 11 cents on Tuesday, to $9.62.

Retzer figures that the bond market’s Angst over inflation has been grossly overdone. He believes the Fed is successfully slowing the economy to a manageable growth rate (look at the weakening housing sector, he says) and that that will allow long-term interest rates to come down. “We think long rates will be significantly lower by the end of the year,” he said.

Retzer also believes that the bond market has something going for it that’s almost as important as the fundamentals: Too many bears. “If this rally shows any staying power, there’s a lot of money on the sidelines waiting to come into” bonds, he said. “Short” sellers who thought yields would continue to rise will have to cover their positions; and bond fund managers who have accumulated piles of cash will feel pressured to put that money to work.

Yet many Wall Streeters still argue that any rally in the bond market ought to be viewed as an opportunity to exit, not to buy. What happens, ask these doubters, if economic statistics continue to look strong well into June? How long before investors again see the specter of higher inflation, and begin clamoring for the Fed to tighten credit again?

Shelby Davis, who manages the New York Venture stock fund, contends that the stock market has a far better chance of mounting a sustainable rally here than the bond market.

Think of it this way, Davis says: If the economy is stronger than the Fed yet knows, interest rates will jump again (bad for bonds), but corporate profits will be stronger as well (good for stocks); and if the Fed has achieved its goal of moderating growth without bringing on a recession, interest rates may stabilize, but continuing growth in corporate profits should prove the bigger lure for investors.

“The capital gains play in bonds isn’t there,” Davis argues, while it still is for stocks, he says.

Ready to Pop?

Investment newsletter writers’ sentiment toward stocks has grown increasingly negative in recent weeks, and the percentage of newsletters bullish on the market now is at a 3 1/2-year low--which could, perversely, signal a short-term rally.

Investors Intelligence investment newsletter poll:

1994

Bulls Bears Jan. 7 38.8% 38.8% Jan. 14 40.6 38.7 Jan. 21 39.8 38.9 Jan. 28 40.4 40.4 Feb. 4 38.7 38.7 Feb. 11 39.5 38.5 Feb. 18 39.3 40.2 Feb. 25 38.5 40.4 March 4 39.1 40.0 March 11 34.8 40.2 March 18 37.2 37.2 March 25 39.8 39.8 April 1 42.1 38.6 April 8 41.6 39.8 April 15 34.5 43.4 April 22 33.6 46.0 April 29 29.1 50.4 May 6 30.2 50.8 May 13 29.1 50.4

Newsletters that are neither bullish nor bearish expect a short-term correction in stocks.

Source: Chartcraft Inc.