Fed Gives Street What It Wants : Trading: Bond yields tumble and the Dow rebounds with a 34-point gain. Was the central bank protecting markets?

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.

Many analysts greeted the Fed’s move with great relief, saying the official quarter-point cut in the overnight federal funds rate--from 5.75% to 5.5%--could be enough to ensure that this year’s phenomenal gains in stocks and bonds don’t evaporate early in 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.

Immediately after Tuesday’s rate cut the bond market turned ebullient, 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.

Monday’s stock slump 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.”

In theory, the Fed worries only about the economy and inflation, trying to keep the former growing moderately without stoking the latter. In its terse official explanation Tuesday the central bank mentioned only lower-than-expected inflation as a reason for the rate cut.

Would the Fed really care if the red-hot stock and bond markets were slammed by profit taking after their big 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.

Whatever its true motivation, the Fed’s decision naturally has powerful implications for stocks and bonds. How some analysts see markets shaping up as 1996 approaches:

* Bonds: The Fed’s rate cut probably guarantees that long-term bond yields will at worst tread water over the next month, and may eventually fall enough to test the 1993 low of 5.79% on the 30-year T-bond, many experts say.

Although bond yields are already at levels that assume the Fed must cut rates further, the bond market now 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. What’s more, the Fed itself is waxing positive about inflation--Public Enemy No. 1 for bonds.

Although profit-taking could make the bond market choppy in coming weeks, some analysts believe that the Fed has set the stage for a fresh rally once President Clinton and Congress agree on a balanced-budget plan.

“If we get a budget deal we have a chance to get into the 5s [5% to 6%] on T-bonds,” said Lereah. But he cautions that that will require a continuation of data showing a relatively weak economy.

* Stocks: Wall Street’s great bull market of 1995 should be well-supported early in 1996 by the Fed’s move, many analysts say.

“This stabilizes the market,” says Marshall Acuff, investment strategist at Smith Barney in New York.

But can prices move sharply higher? William Dudley, economist at Goldman Sachs & Co. in New York, believes stocks are a better place to be than bonds in the near-term, because lower interest rates are generally the market’s favorite tonic.

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.

But Acuff cautions that corporate earnings growth overall is slowing, so the market will become more discriminating. To make money, “Investors will [have] to focus on the stocks that have the earnings growth,” he says.

* 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