Mere Talk of Fed Rate Hike Puts Dow in Tailspin
In its spectacular surge this year, the U.S. stock market has shaken off slowing corporate earnings, the financial crisis engulfing much of Asia and constant reminders about share prices’ unprecedented heights.
But Monday’s nearly 150-point drop in the Dow Jones industrial average demonstrated again that the one force Wall Street can’t ignore is rising interest rates--or even the threat of rising rates.
Concern that the Federal Reserve Board will boost rates to slow the economy, perhaps as soon as its next policy meeting on May 19, sent stock and bond markets into a tailspin Monday. The Dow fell as much as 224 points before recovering late in the day to close down 146.98 points, or 1.6%, at 8,917.64.
In the bond market, the yield on the 30-year Treasury bond, a benchmark for long-term interest rates, such as mortgage rates, rose above the psychologically important 6% level to finish at 6.05%, up from 5.94% on Friday.
Stocks had rallied strongly since mid-January, lifting the Dow from 7,600 then to a record 9,184 last week, on a pair of intertwined assumptions: Interest rates would remain tame because Asia’s woes would eventually beat back the U.S. economy’s robust growth rate.
In fact, early in the year some economists asserted that Asia’s troubles could be negative enough for the U.S. economy to perhaps even persuade Fed Chairman Alan Greenspan to cut interest rates to preclude the chance of Depression-style deflation, or progressively lower prices, taking hold.
But most data now point to a still-strong economy. Instead of slowing because of weaker export demand and a flood of cheap Asian imports, the U.S. economy has been paced by low unemployment, rising wages and a red-hot housing market.
And the Fed--forever worried about the potential for the economy to overheat and fuel higher inflation--has lately turned up the rhetoric about a possible rate hike to preemptively knock out inflation.
Monday’s sell-off was triggered by a Wall Street Journal story saying that Fed policymakers at their March 31 meeting leaned toward raising rates in coming months.
The minutes of the March 31 meeting are confidential and are not scheduled to be made public until May 21, two days after the Fed’s next meeting.
But even before Monday’s report, a number of Fed officials have in recent weeks warned that investors should expect a boost in the central bank’s benchmark short-term interest rate, the federal funds rate, which is now at 5.5%.
A week ago, for example, Fed Governor Roger Ferguson specifically stated that the central bank will raise rates if Asia doesn’t cool the U.S. economy. “Either Asia will slow the economy to something that is more sustainable or there will have to be some Fed action that will do that,” he said.
While investors can overlook other challenges to the now 7 1/2-year-old bull market, they can’t dismiss rising interest rates. Higher rates can hurt corporate earnings because companies’ borrowing costs climb just as demand for their products falls off, as the economy slows.
*
And as interest rates on bonds and other fixed-income securities edge higher, some investors dump stocks to buy bonds.
Perhaps most troubling is that this year’s stock rally has been built in large part on the premise that rates would remain low.
Stock prices have been extremely high for some time in relation to underlying fundamentals, such as companies’ sales and earnings. But the market’s bulls have argued that the high valuations were justified because inflation and interest rates are low.
“We’ve gotten to a point where the stock market is pretty pricey on just about every measure of interest-rate valuation you want to look at,” said Jeffrey Applegate, chief investment strategist at brokerage Lehman Bros. in New York.
Thus, any increase in rates could be expected to automatically push stock values lower.
Yet there is no sign yet that inflation--the Fed’s major concern--is heading up with the strong U.S. economy. In fact, consumer prices have been climbing recently at an annualized rate of just 1.4%, one of the lowest rates in post-World War II history.
And though several Fed officials have unleashed warnings, Greenspan himself has been silent lately. Given that Greenspan has in the recent past personally spoken of rate hikes before implementing them, some economists doubt he’s about to move.
Instead, the Fed may simply be trying to “jawbone” the economy--and stock prices--lower by threatening a rate increase. If the effect of that jawboning is to temporarily send long-term bond yields (and mortgage rates) higher, and stock prices down, the Fed could succeed in slowing economic growth.
“The Federal Reserve is going to let the air out of the bubble slowly and gradually rather than with [a single] prick,” said Sung Won Sohn, economist at Norwest Corp. in Minneapolis. “They have been using what they call the open-mouth policy very effectively.”
Though the Fed historically has not been concerned with the stock market’s levels, there is growing fear among many economists that the tremendous wealth that rising stock prices generated for many Americans is adding fuel to the economy’s fire by encouraging spending on goods and services.
Despite Monday’s market sell-off, a number of stock pros still doubt the Fed will boost rates this year. Others argue that, even if the Fed does act, it will raise rates only moderately and won’t derail the bull market for long.
Abby Cohen, strategist at brokerage Goldman, Sachs & Co. and one of Wall Street’s best-known bulls, believes rates will head up at some point. “The question is when and by how much. The answer is not soon and not much.”
Nevertheless, even the specter of rising rates can be enough to shake the stock market.
The Fed last raised short-term rates on March 25, 1997, by a quarter of a percentage point, to 5.5% from 5.25%. The market peaked two weeks earlier, on March 11, with the Dow at 7,085.16 as it became increasingly clear that Greenspan would act. The Dow then skidded into a monthlong 9.8% correction, bottoming on April 11. But it quickly rebounded as investors concluded that further rate hikes were not in the offing.
In 1994 and early 1995, when the Fed raised rates repeatedly, the market suffered for an extended period. The Dow gained barely more than 2% in 1994, even though corporate earnings improved strongly throughout the year. Some market watchers came to label 1994 a “stealth correction.”
With inflation quiescent, though, few on Wall Street expect a repeat of 1994. “It is at worst a onetime move” if the Fed boosts rates, said Joseph Battipaglia, strategist at Gruntal & Co.
Treasury Secretary Robert E. Rubin, asked Monday in Boston about the economy’s prospects, repeated his belief that “the problems in Asia will . . . most likely result in lower inflation in this country and lower interest rates” over time.
Still, analysts warned that the stock market is vulnerable to a steeper decline near-term.
“We continue to go through these recurrent periods in which investors feel good and then feel bad,” said Marshall Acuff, a strategist at Salomon Smith Barney Inc. “All this is very typical of bull markets. In bull markets, you get corrections of 5% to 10%, and it’s no big deal.”
“For a number of reasons, the market was overdue for a setback,” said Elizabeth Mackay, strategist at Bear, Stearns & Co.
*
For example, many Wall Streeters were unnerved by the speculative frenzy that gripped Internet-related stocks last week, with some risky small stocks doubling or tripling in a single day. Such hysterical buying has been a precursor of at least temporary market tops as investors get greedy and start throwing money around.
Corporate earnings growth has also worried Wall Street lately. Thus far, first-quarter earnings of blue-chip companies are on pace to rise about 3% from a year ago, overall, according to First Call Corp. That would mark the weakest quarter since 1991.
Bears say the market can’t keep rising if corporate earnings aren’t there, while bulls counter that earnings growth will re-accelerate in the second half of the year.
*
* GLOBAL SELLOFF
Stocks fell worldwide on rate worries and on fresh concern about Japan’s economy. D1
