The Fed Is Walking a Fine Line With Year's 6th Rate Hike

By TOM PETRUNO

Nov. 16, 1994 12 AM PT

The Federal Reserve Board has made “cash” investments king this year by pumping up short-term interest rates. With Tuesday’s sixth Fed rate boost of 1994, the crown still rests easy on cash’s head, many Wall Streeters say.

The Fed’s 0.75-point rate hike sparked instant rallies in stock and bond markets, but they didn’t stick. Virtually all of the buying excitement faded in a matter of minutes.

By the close, the Dow industrials had lost a minuscule 3.37 points to 3,826.36, and bond yields finished mixed, with the 30-year Treasury rate at 8.03% from 8.07% on Monday.

Taken together, stocks’ and bonds’ response was by far the most muted market reaction to any of the Fed’s rate increases this year and a far cry from what transpired when the central bank last raised rates on Aug. 16. That day, the Dow index jumped 24 points and the 30-year T-bond yield tumbled from 7.50% to 7.36%.

After six rate hikes--the previous two or three of which were widely and wrongly hailed on Wall Street as the Fed’s “last” for a while--many investors now are understandably reluctant to view the latest increase as some kind of watershed.

Having underestimated the strength of the economy for most of this year and the Fed’s response to it, it’s difficult for most veteran investors to believe that Tuesday’s rate boost was the final one in this economic cycle.

At the same time, rates have reached levels that, in theory, should begin to have a meaningfully restraining effect on the economy--and therefore on investors’ fears of significantly higher future inflation and interest rates.

If the Fed--and the rest of us--are lucky, the outcome will be a moderately growing economy in 1995. But if Chairman Alan Greenspan and his cohorts have overdone it, the surprise could be that recession will become the next big worry.

What’s the best strategy for individual investors at this point? Here’s a look at prospects for bonds, stocks and money market investments:

* Bonds: Narrowing the spread. Most economists had expected the Fed to raise rates half a point Tuesday, so the 0.75-point boost clearly caught the market somewhat off guard.

With the Fed putting more serious upward pressure on short rates to rein in the economy, investors immediately adjusted other short- and intermediate-term yields accordingly. The yield on the two-year Treasury note jumped to 7.10% from 7.03% on Monday. Even five-year T-note yields rose, to 7.68% from 7.64%.

At the same time, longer-term bond yields dipped or held steady. The result: a further “flattening” of the so-called yield curve. That is, the spread between short-term interest rates and long-term rates continued to narrow Tuesday.

Early in 1993, 30-year T-bonds yielded three points more than two-year notes (7.21% versus 4.20%). On Tuesday, that spread fell to just under one point (8.03% versus 7.10%).

What’s the message in a narrowing yield spread? Some Wall Streeters say it’s a sign that the market increasingly believes the Fed will be successful in engineering a slowdown in the economy that keeps inflation low. “It tells you that what the Fed wants to happen may be happening,” says Stan Nabi, strategist at Bessemer Trust in New York.

If the market believed that the economy and inflation were poised to roar in 1995, long-term bond yields might still be rising as rapidly as short-term yields. Instead, even though long yields have jumped this year, the pace of increase hasn’t kept up with short yields, especially since summer.

That is bolstering some market players’ hopes that long-term yields are nearing a peak for this economic cycle--which could finally begin to draw buyers back to long bonds. Yet many pros still advise approaching the bond market with caution. Nibbling is OK; huge bets aren’t wise.

Kevin Flanagan, economist at Dean Witter Reynolds, says the best the long end of the market can expect is some stability for awhile, but not a sharp decline in yields. Typically, long yields fall dramatically only when the Fed finally begins to cut short rates again. And notably on Tuesday, the Fed made no reference to this rate hike possibly being the last--the unfortunate comment that Greenspan optimistically allowed in August.

* Stocks: Mostly a lose-lose proposition? No surprise that stocks quickly sold off after the brief post-rate-hike rally at midday Tuesday, many Wall Streeters say. With short-term interest rates at their highest levels in more than three years, the stock market is increasingly finding itself wedging deeper between the proverbial rock and hard place.

If the market fantasizes that Tuesday’s Fed rate boost might be the final one, the conclusion that naturally follows has to be that the economy is slowing--a problem for corporate earnings growth.

If the market figures the Fed isn’t nearly done raising short rates, the competition for investors’ dollars from money market accounts and bank CDs (let alone bonds) will only become more intense.

Since the last Fed rate increase, in August, the stock market overall has gone nowhere. But under the surface, investors have been dumping the industries that suffer first from a bona fide economic slowdown, while hunting for industries whose growth may not depend on the economy generally. That’s a stock-picker’s game--which means it’s possible to make money in the market today, but not without great effort.

* “Cash”: Still the winner. The only clear beneficiaries of Tuesday’s Fed rate boost are the same people who have been winning all year--investors who are keeping a large amount of their assets in money market funds, Treasury bills and short-term bank CDs.

The Fed’s latest move will assure that cash account returns, now 4% to 6.5%, will continue to climb in the near term. Gary Schlossberg, economist at Wells Fargo, notes that “the investor who stays short is the most flexible.” In an uncertain economy and markets, flexibility is worth a lot.

The Narrowing Spread

Though short- and long-term interest rates have jumped in tandem this year, short rates have risen much faster. Some experts say the narrowing spread between short and long rates implies that the economy is finally poised to slow.

30-year T-bond Tuesday: 8.03%

2-year T-note Tuesday: 7.10%

Source: TradeLine

Wall Street’s View as Interest Rates Rise

Here are the stock industry groups that have risen the most and declined the most, on average, since the Fed last raised interest rates in mid-August.

Winners

Commun. equip.: +23.8%

Electron. instrum.: +22.5

Soft drinks: +17.1

Computer systems: +17.0

Software: +15.5

Drugs: +12.8

Drugstores: +12.6

Can-bottle makers: +11.7

Household prods.: +10.4

Grocery stores: +10.1 Losers

Group: Pct. change since Aug. 15