Respite for Investors : Yields Edging Down Slowly While Stocks Recoup Losses

After a dismal winter and early spring, financial markets have taken a surprising turn for the better in recent weeks. Without much fanfare, many investors are seeing their stock and bond assets rise in value once again, if at a snail’s pace:

* Bonds have been slowly appreciating as market yields have edged lower, after rocketing almost nonstop since late January.

The 30-year Treasury bond yield, the benchmark for long-term interest rates, has dropped to 7.26% now, after surging from 6.35% at year’s end to a peak of 7.65% on May 9. Yields on some other types of bonds, such as tax-free municipal issues, have fallen even faster than Treasury rates.

* The stock market, taking a cue from bonds, has rallied modestly since mid-May, raising hopes for the proverbial “summer rally” on Wall Street.

The blue chip Standard & Poor’s 500-stock index, which slumped 5.2% between Jan. 1 and May 9, has gained 3.6% since. And the Dow Jones industrial average, 3,755.91 at Tuesday’s close, has recouped all of its losses and now is slightly above its year-end close of 3,754.09.

The credit for the markets’ healthier tone, of course, goes largely to the same entity responsible for driving investors into a selling frenzy earlier in the year: the Federal Reserve Board.

The Fed’s decision to begin tightening credit on Feb. 4, for the first time in five years, was the equivalent of yelling “Fire!” in a crowded movie theater. By raising short-term interest rates from 30-year lows, the Fed in effect booted speculators out of the stock and bond markets, and focused bond owners on the idea that the economy was growing fast enough to reignite inflation, bonds’ No. 1 fear.

But just four months after the Fed’s policy shift, the central bank’s principal goal--to slow the economy to a moderate pace, with low inflation--appears to have been achieved. Or at least that’s what the Fed apparently believes.

In public and private statements over the past few weeks, Fed officials have strongly projected the idea that they’re satisfied with their policy and now are comfortable leaving short-term interest rates alone for the foreseeable future.

On Wall Street, the promise of a benign Fed has proved to be a powerful tonic. A key moment for the markets occurred last Friday, when the government reported a sharp drop in the May unemployment rate, but stock and bond markets failed to view the report as a reason to resurrect old worries about excessive growth and inflation. Bond yields actually edged lower on Friday.

With the Fed’s recent soothing tone, “the market is accepting that these yields (on bonds) are appropriate for the likely events in the economy” in the near-term, says Kevin Logan, economist at Swiss Bank Corp. in New York.

Peter Anderson, president of money manager IDS Advisory Group in Minneapolis, notes that the market isn’t just taking the Fed at its word. Despite the puzzling unemployment report, many of the economic indicators of late have suggested “that the economy is slowing just a tad,” Anderson notes.

In addition, the bond market has been helped by other factors, Anderson says. A plunge in grain and soybean prices over the past week, as much-needed rain fell on the Midwest, has helped further reduce inflation worries. And a strengthening dollar has given foreign investors new incentive to buy U.S. bonds and stocks .

*

But everyone knew bond yields would stabilize eventually. The big question now is whether they can continue to fall.

Many experts don’t expect a sharp decline in yields from current levels. More likely is that yields will trade in a narrow range for at least a few months, until it’s clear that the economy is either slowing further, accelerating again or continuing to grow at the same moderate pace.

Swiss Bank’s Logan, for example, figures the 30-year Treasury bond yield, now 7.26%, will bounce between 7.1% and 7.6% this summer as traders push the market to and fro, alternately starting rallies and then selling into them.

William Gross, a principal at bond giant Pacific Investment Management Co. in Newport Beach, figures the T-bond yield range this summer will be 7% to 7.5%. “There’s probably not going to be a lot of excitement in the bond market relative to what we’ve seen” in recent months, Gross says.

For many bond investors, a lack of excitement would be welcome, after the losses incurred in the market in winter and early spring. But experts also caution investors to use this period of relative calm to assess whether they should stay in bonds. If the economy booms again later this year or in 1995, interest rates could surge anew, causing more principal losses for bond owners. Investors who don’t want to take that risk should view the current rally as a way out, investment advisers say.

Opportunists and long-term investors, however, may want to take a different approach: Which bonds offer the best value today, if you figure the economy is sure to slow a bit more or remain on a moderate-growth track?

Many bond pros say the high-yield “junk” corporate bond market is a good bet, because junk yields haven’t yet dropped in line with yields on Treasury bonds since mid-May--even though junk bonds’ fundamentals are solid. “I think the high-yield market is in great shape,” says Frederick Cavanaugh, manager of the John Hancock Strategic Income fund in Boston.

For a simpler bet, Pacific Investment Management’s Gross says investors should look at intermediate-term Treasury securities. The yield on five-year T-notes, for example, is 6.52% now. At that level, Gross says, the market is already assuming that between now and the end of the year, the Fed will raise short-term interest rates another full percentage point. Gross doubts the economy will be strong enough to justify that kind of move.

What about stocks? David Shulman, strategist at Salomon Bros., thinks the market will see its traditional summer rally if interest rates stay tamed. He expects the Dow to near its all-time high of 3,978. But the leaders in a summer rally, like the leading stock groups so far this year, will be an eclectic mix, Shulman says; names like Microsoft, Georgia-Pacific and Unocal are on his list.

Anderson of IDS says the most logical stock market bet now is a replay of the last two years, in condensed version: Bank and other financial stocks have already rallied over the past month, he notes, as bond yields have fallen. The next move, Anderson says, should be in some of the economy-sensitive stocks that have been beaten down since winter--autos, retailers and airlines, for example. If the Fed has succeeded in stretching out the economic recovery at a moderate pace, investors should be drawn back to stocks of auto makers and other companies whose “peak” recovery earnings may be years away, he says.

Better Times for Stocks and Bonds?

The bond market’s rally in recent weeks has raised hopes that long-term interest rates are about to pull back sharply from their recent highs, which also could give a further lift to stocks.

TREASURY BOND YIELDS DIP . . .

30-year Treasury bond yield; weekly closes, except latest 1994 Jan. 1: 6.35% Jan. 7: 6.22% Jan. 14: 6.29% Jan. 21: 6.28% Jan. 28: 6.21% Feb. 4: 6.35% Feb. 11: 6.40% Feb. 18: 6.62% Feb. 25: 6.71% March 4: 6.84% March 11: 6.90% March 18: 6.91% March 25: 7.01% April 1: 7.08% April 8: 7.25% April 15: 7.28% April 22: 7.22% April 29: 7.30% May 6: 7.55% May 13: 7.49% May 20: 7.30% May 27: 7.39% June 3: 7.26% TUES.: 7.26%

. . . PULLING OTHER INTEREST RATES DOWN . . .

Average annualized bond yields, by category

May 9 Tuesday Junk bonds 10.63% 10.53% GNMA bonds 8.44% 7.98% Muni revenue bonds 6.54% 6.07%

Source: Merrill Lynch & Co. indexes

. . . AND SPARKING A TURNAROUND IN STOCKS

Percentage change: Index Jan. 1 to May 9 Since May 9 S&P; 500 -5.2% +3.6% Dow industrials -3.3% +3.5% Nasdaq composite -6.9% +2.3%

Stock Group Trends

Here are the biggest winners and losers among 88 stock industry groups since Jan. 1.

WINNERS

1994 Group change Engineering +21.1% Hospital cos. +20.7 Chemicals +17.8 Leisure time +13.6 Cosmetics +13.0 Alcoholic bevs. +12.6 Shoes +11.3 Pollution control +11.2 Regional banks +10.1 Major banks +7.4

LOSERS

1994 Group change Comp. software -42.0% Home builders -34.5 Airlines -19.7 Electric utils. -17.9 Building mater. -16.9 Photography -16.6 Misc. health care -15.9 Gold mining -15.4 Spec. chemicals -13.9 Hotels, motels -12.7

Source: Smith Barney, using Standard & Poor’s indexes