IMPACT OF THE RATE CUT : Easier Fed Is Wall Street’s Best Friend
Alan Greenspan & Co. gave financial markets what they wanted Thursday. Or rather, what they were demanding.
The Federal Reserve Board’s quarter-point reduction in its benchmark short-term interest rate, to 5.75%, set off spectacular rallies in stock and bond markets and fueled predictably bullish projections of more to come.
But what really motivated buyers, and will probably continue to motivate them, isn’t the relatively puny rate cut that the Fed sanctioned on Thursday. Rather, it’s the belief that one Fed rate cut inevitably leads to more.
“This has got to be the beginning of an easing cycle by the Fed,” declared Scott Grannis, economist at Western Asset Management in Pasadena.
And when the Fed is on the markets’ side, it’s an understatement to say that is a positive influence on investor psychology. An accommodative Fed is Wall Street’s best friend.
The only question now is just how accommodative the central bank will be. That will depend on the economy, of course, but history provides guidance.
Merrill Lynch & Co. economist Donald Straszheim noted that the Fed has never cut its federal funds rate, the overnight loan rate among banks, by a quarter of a point, only to quickly raise it again. Rather, “any time the Fed has begun an easing process, it never eased by less than 75 basis points [three-quarters of a percentage point],” Straszheim says.
The message there--or at least the hope--is that the Fed must believe that its 1994 campaign to tighten credit and slow the economy has succeeded and that it can comfortably loosen the screws.
The last thing the Fed wants to do is cut rates too early, then be forced to raise them again a month or two later. You don’t knee-jerk a $6-trillion economy.
Inundated with mostly weak economic data over the past six months, the Fed board apparently decided there was very low risk that business and consumer activity might snap back this summer and make its vote to ease look premature, said Eric Miller, strategist at DLJ Securities in New York. “I think they must feel there is nothing yet suggesting a turn in the economy.”
Even so, analysts point out that the Fed is less a leader than a follower with Thursday’s rate cut. Short-term and long-term market interest rates have been falling since the start of the year as the economy has lost steam.
In effect, the bond market made it very difficult for the Fed not to cut rates, given that yields on Treasury notes maturing as long as five years from now had already fallen below the (previously) 6% federal funds rate.
And as investors rushed into bonds again Thursday, they demonstrated the market’s conviction that the Fed is far from finished with its cutting. “The market is looking around the corner to the next Fed rate move,” said David Schroeder, bond fund manager at the Benham Group of mutual funds in Palo Alto.
What will the Fed’s change of heart and investors’ expectations mean for bond and stock markets in coming months? A quick overview:
* The bond market: With Thursday’s rally, Wall Street appears to be anticipating at least another quarter-point cut in the federal funds rate, and possibly more. That’s evident because the yield on three-month Treasury bills ended at 5.54%, and that rate often tracks federal funds closely.
Gary Schlossberg, economist at Wells Fargo in San Francisco, believes that economic growth may be muted enough between now and the end of the year to allow the Fed to cut its benchmark rate to 5% by then. If he’s right, shorter-term interest rates in general could fall much further, despite their dramatic declines since January.
What’s more, Greenspan went out of his way Thursday to single out lessened inflation fears as the primary reason for the Fed’s rate cut. Despite upward pressure on inflation in the early months of this year, the Fed must believe that price increases will be dampened by the weak economy.
And if inflation isn’t a threat, then long-term bond yields--which key more off inflation than short-term rates--also may be able to fall further, many analysts say. “We could see a 6% or 6.25% long-term [Treasury] bond yield by the end of the year,” down from 6.49% now, said Patrick Retzer, bond fund manager at the Heartland Group of mutual funds in Milwaukee.
Still, experts note that a drop to 6% from 6.5% in the long-term T-bond yield wouldn’t produce the kind of capital gains that enhanced long-term bond mutual fund returns in the first half of this year, as the T-bond’s yield declined from 7.88% at Dec. 31. So unless a recession is brewing--causing interest rates to collapse--the best that bond buyers can hope for at this point is to earn current interest and perhaps reap a small capital gain.
The big risk, of course, is that the Fed was in fact premature with its rate cut and that the economy comes roaring back by fall. If that happens, “it’d be a terrible shock to bonds,” concedes Western Asset’s Grannis.
* The stock market: Investors’ attitude Thursday was “all buy, buy, buy,” said Rao Chalasani, strategist at Kemper Securities in Chicago. But then, that has described Wall Street all year.
Should sentiment change now, with the Fed finally giving the stock market what it wanted? Certainly, it’s prudent for analysts to warn that a pullback of some magnitude is overdue, even with the Fed’s easier-money stance.
Yet Chalasani admits he can’t easily identify “the trigger to bring the market down.”
Stephen Slifer, economist at Lehman Government Securities in New York, notes that with interest rates falling, stocks automatically become more attractive relative to bonds. If you assume the economy stays afloat and inflation stays low, “this has got to be a dynamite scenario for stocks,” he says.
But won’t a weaker economy--the basis for the Fed’s rate cut--also produce weaker corporate earnings? For many companies, that will undoubtedly be true. The psychology of the stock market this year, however, has been to look past current anemic growth to strength later on, in 1996. And nothing suggests that that bullish-no-matter-what mentality is about to change.
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How Bond Funds Fared
Here are average total returns for key categories of bond mutual funds for three periods ended June 30. Total return includes interest earnings plus or minus any change in the bonds’ principal value.
Average total return Fund category 2nd qtr. 6 mos. 12 mos. Lower-quality corporate bonds, long-term +6.68% +11.8% +12.6% Global bonds, long-term +6.63% +10.2% +10.6% Mixed bonds +6.37% +10.7% +9.7% High-quality corporate bonds, long-term +6.14% +11.4% +11.8% U.S. govt. bonds, long-term +5.69% +10.5% +10.9% High-quality corporate bonds, 5- to 10-year +5.59% +10.2% +10.9% Junk corporate bonds +5.14% +9.7% +8.2% GNMA bonds +5.13% +10.2% +11.2% U.S. govt. bonds 5- to 10-year +5.08% +9.6% +10.0% High-quality corporate bonds, 1- to 5-year +3.45% +6.5% +7.3% U.S. govt. bonds, 1- to 5-year +3.42% +6.8% +7.3% Global money market +3.31% +3.1% +1.7% General muni bonds, long-term +1.91% +9.0% +7.7% Calif. muni bonds, long-term +1.77% +9.7% +7.7% Adjustable-rate mortgage bonds +1.44% +3.0% +1.6% Money market +1.35% +2.7% +4.9%
Source: Lipper Analytical Services Inc.
