Rising Euphoria Over Fed Hopes Warrants Caution

Teen-agers should be so lucky with their parents: No matter what news you throw at financial markets today, they like it. A lot.

That was readily apparent on Thursday, as the latest batch of weak economic statistics sent bond yields to 21-month lows and the Dow Jones industrials to a record high.

Whereas evidence of a struggling economy had in recent months sparked worries about corporate earnings--leading to a sharp selloff in certain stocks--now the view of economic trouble is that it’s just the tonic Wall Street has been pining for.

How else to explain major retail stocks’ surge on Thursday, even though most retailers reported dismal October sales?

In the bond market, the threat of default by the U.S. Treasury--as President Clinton and the Republican-controlled Congress battle over a balanced-budget plan and the soon-to-be-reached federal debt ceiling--has done little to deter buyers. On the contrary, one school of thought is that many bond investors would actually savor a forced default as a sign that Republicans won’t compromise on the cherished goal of a deficit-free Uncle Sam by sometime in the next decade.

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Of course, this isn’t the first time Wall Street has operated in bad-news-is-good-news mode. The stunningly bullish first half of this year for both stocks and bonds was driven largely by the belief that the economy would ebb from 1994’s brisk pace, which it did.

Then, as now, markets ultimately became focused on a single idea: that the Federal Reserve Board was certain to cut short-term interest rates, and that such a move by the Fed would by itself be enough to sustain investors’ party mood.

Today, it’s tough to find anyone on Wall Street who doesn’t think there’s an overwhelming probability that the Fed will cut rates by at least a quarter point at its Dec. 19 meeting, if not sooner. “I think they need to ease even if there’s no [federal] budget agreement, because the economy is weakening again,” declares Maury Harris, economist at PaineWebber Group in New York, in an oft-echoed refrain.

And if we get a budget deal--well, Katy, bar the door! Wouldn’t bond yields collapse and stocks zoom in the euphoria that would surely follow?

Maybe not. Some worried pros advise investors to consider the possibility that markets now are doing exactly what they’re supposed to do, which is to anticipate the future.

In other words, with each new low in bond yields, and each new high in stock prices, there is that much less likelihood of an immediate, dramatic rally after any budget accord is struck, and-or after the Fed cuts rates again. By then, expectations should have caught up completely with reality, and the logical decision for many investors--or at least traders--should be to sell.

“Hopes are growing that the mother of all bull rallies is about to be unleashed in the U.S. bond market,” says a dubious Stephen Roach, economist at Morgan Stanley & Co. in New York. Instead, he argues that “the coming compromise on [federal] deficit reduction will offer the classic opportunity to ‘buy the rumor, sell the news.’ ”

Recent history suggests he may be right in warning nervous bond investors to be sellers rather than buyers here. The Fed’s July 6 rate cut, the first in three years, was followed not by a rally in bonds but by a surprising selloff. The yield on the 30-year Treasury bond, 6.50% on July 6, ran back up to almost 7% by early August.

It’s important to note that Roach isn’t predicting a new bear market in bonds. He just believes that the excitement over the Fed’s probable next move and any budget deal has stretched valuations too far, too fast. Patient investors will get better yields in the next few months, he contends.

What about stocks? Share prices clearly lost their momentum in the weeks after the July 6 Fed cut, and some bears would argue that, despite new highs in key indexes like the Dow, the market has mostly been churning since mid-July. Nonetheless, the Standard & Poor’s 500-stock index is 6.4% higher today than it was on July 6.

John Williams, economist at Bankers Trust Co. in New York, concedes that some investors may be motivated to take profits once the Fed trims rates again, given the extent of stocks’ 1995 gains.

Yet history shows that two consecutive Fed rate cuts almost inevitably mean higher stock prices 12 months later (the “Two Tumbles and a Jump” market axiom). There simply is no better friend to stocks than an accommodative Fed within a moderately growing, low-inflation economy, Williams says. “What the stock market likes better than anything is a long, sustainable [business] expansion,” and that’s what we’ve got, he reminds.

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Lower and Lower

Investors continue to push long- and short-term interest rates down, as the economy wavers and as inflation remains benign.

Thursday

30-year T-bond: 6.24%

5-year T-note: 5.66%

6-month T-bill: 5.46%