Fed Gives Street What It Wants : Markets: Bonds rally and the Dow rebounds with a 34-point gain. Does the central bank actually care?
The Federal Reserve Board’s action Tuesday to trim one of its key short-term interest rates sparked a solid stock and bond rally and gave Wall Street all it really wanted for Christmas: a sense of hope for more.
After a tense morning for financial markets following Monday’s disturbing sell-off, investors began scooping up stocks and bonds soon after the Fed’s midday announcement from Washington.
The bond market fared best, with the bellwether 30-year Treasury bond yield sliding to 6.10% from a morning peak
of 6.24%. That left the yield just slightly above Friday’s close of 6.09%.
In the stock market, the Dow Jones industrial average closed with a gain of 34.68 points at 5,109.89, recouping about a third of Monday’s 101.52-point plunge.
Many analysts greeted Tuesday’s Fed move with a sense of relief, saying the official quarter-point cut in the overnight federal funds rate--from 5.75% to 5.5%--will help prop up this year’s phenomenal stock and bond rallies as jittery investors enter 1996.
Indeed, the Fed’s decision was widely viewed as a sort of tranquilizer for markets after Monday’s turmoil, which had been triggered at least in part by fears that the central bank wasn’t prepared to ease credit at all--let alone by the half-point that Wall Street had already built into short-term market interest rates in recent months.
Monday’s stock plunge was “the equity market [saying], ‘Could you help us?’ ” said Steven Guterman, a managing director at Salomon Bros. Asset Management in New York.
The Fed’s decision “was definitely a symbolic gesture to the markets,” said David Lereah, economist at the Mortgage Bankers Assn. in Washington. “Maybe the 100 points [off the Dow index on Monday] scared them.”
But--in theory, anyway--the Fed worries only about the economy and inflation, trying to keep the former going without stoking the latter.
In its terse official statement Tuesday, the central bank said merely that “inflation has been somewhat more favorable than anticipated” lately, thus paving the way for a rate cut.
There was no mention of a slowing economy--the factor that many analysts believe is the most important justification for lower rates.
And there was certainly no mention of weak financial markets.
Would the Fed really care if the red-hot stock and bond markets were slammed by profit taking after their tremendous rallies this year? Or to put it another way, if Fed governors were unsure whether the economy was truly slow enough to merit lower interest rates, would a threatened market sell-off be enough to tilt them toward easing?
Fed purists say no. They note that this Fed, under Chairman Alan Greenspan, had no qualms about busting the markets’ bubble in February 1994 by initiating a yearlong sequence of interest rate increases designed to slow the economy’s then-torrid pace.
But John Lonski, economist at Moody’s Investors Service in New York, contends that Greenspan & Co. may view financial markets in a different light today.
In 1994, consumer and business spending was clearly robust enough to keep the economy growing even as the Fed tightened credit. Now, Lonski says, one can argue that “the U.S. economy doesn’t have enough going for it” to guarantee even moderate growth if there should be any shocks to the system--such as plummeting markets.
“You need healthy stock and bond markets to maintain economic buoyancy in 1996,” Lonski says. A strong stock market, he notes, provides at least some support for consumer spending by making people feel wealthier; a strong bond market keeps mortgage rates down and allows businesses to continue refinancing debt at lower rates, improving their balance sheets.
If the Fed governors were as confused as everyone else about just how weak the economy really is, they could conceivably decide that the one thing they don’t need is a market crash to provide a litmus test.
Ironically, the repeated failure of the federal balanced-budget negotiations between President Clinton and Congress also may have provided the Fed with a reason to cut rates--not to outwardly help either side, but rather to demonstrate the Fed’s independence from the political process.
Paraphrasing from Clinton’s old campaign book, the Fed is, in effect, saying, “It’s inflation, stupid! That’s what we focus on--not these political shenanigans.”
Whatever its true motivation, the Fed’s decision Tuesday probably guarantees that long-term bond yields will at worst tread water over the next month, and may fall enough to test the 1993 low of 5.79% on the 30-year T-bond, many analysts say.
Although bond yields are already at levels that assume the Fed must cut rates further, the bond market has much more confidence in that scenario, because Tuesday’s reduction is the second since July, and historically two Fed cuts usually lead to more.
For that same reason, the bull market in stocks also should be well-supported by the Fed’s move, experts say. Especially if bank savings rates drop anew early in ‘96--a likely event as banks cut their prime lending rates--more Americans may find that stocks offer the only potential for significant returns on their money.
* FED EASES
Central bank lowers key rate by a quarter-point. A1.
* MARKETS RALLY
Fed move triggers broad rally on Wall Street. D3.
(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Key Rate Drops
Federal Reserve Board policymakers cut the target federal funds rate on overnight bank loans to 5.5% on Tuesday, returning it to the level of the beginning of the year.
Dec. 1995: 5.5%
Source: Bloomberg Business News
