Markets Seek Direction as Fed Signals a Pause
Wall Street had only a muted reaction to the Federal Reserve’s much-anticipated interest rate cut on Tuesday, because investors also saw less reason to expect more cuts soon.
A brief rally lifted blue-chip stock indexes about 2% immediately after the Fed’s 2:15 p.m. EST announcement, but most of the gains quickly evaporated.
The Dow Jones industrial average, which has surged over the last six weeks in the wake of the Fed’s first two rate cuts, ended down 24.97 points at 8,986.28, though the market overall was mixed.
In the bond market, longer-term Treasury yields edged up Tuesday, with the bellwether 30-year Treasury bond ending at 5.30%, up from 5.29% on Monday.
Clearly, investors are looking ahead. And those hoping for the Fed to continue easing interest rates in the months to come got a disappointing signal in the central bank’s brief statement:
“With the 75 basis point [0.75 of a percentage point] decline in the federal funds rate since September, financial conditions can reasonably be expected to be consistent with fostering sustained economic expansion while keeping inflationary pressures subdued.”
In other words, Fed watchers said, don’t count on a fourth straight cut when the policymaking Fed Open Market Committee next meets Dec. 22.
What does that mean for markets and the economy near-term?
Certainly, there is good news in the latest rate cut: It may mean continued robust consumer spending and probably a strong holiday shopping season, as the Fed’s action should help reduce rates on many consumer loans and make people less anxious about their debt loads.
Many banks tie their consumer loan rates to the prime lending rate, which was cut at leading banks to 7.75% on Tuesday from 8% on Monday, in tandem with the Fed’s cut. The prime was 8.50% as recently as mid-September.
“The consumer and services sectors have been keeping things going” for the U.S. economy as a whole, said Mario DeRose, bond strategist at brokerage Edward Jones in St. Louis. “This is a very positive move for them.”
And to the extent that the latest rate cut keeps stocks climbing--or at least helps them hold their gains of the last six weeks--there is also reduced worry of a reverse “wealth effect,” wherein drooping stock market investments could cause consumers to cut back on spending.
The Fed’s three quarter-point cuts in the federal funds rate (the overnight loan rate among banks)--on Sept. 29, Oct. 15 and Tuesday--have fueled a stock market rally that has brought the Dow average and the Standard & Poor’s 500-stock index to within 4% of the all-time highs they reached last July.
From their early October lows, the S&P; has risen 24%, and the Nasdaq composite index has leaped a gaudy 43%, boosted by surging technology shares.
Markets worldwide have joined in the rally, bolstered by the belief that cuts by the Fed and other central banks will be enough to maintain investors’ confidence in the global financial system--which was shaken to the core in September and early October by worries over Asia’s economic crisis, Russia’s collapse and the spread of turmoil to Latin America.
But in signaling that it may be finished, for now, in easing credit, the Fed may add more impetus to the recent rebound in U.S. Treasury bond yields--which help determine other long-term interest rates, such as for mortgages.
Treasury yields, which often anticipate Fed moves, sank sharply in September, foreshadowing the Fed’s first rate cut.
But in recent weeks short- and long-term Treasury yields have snapped back. At 5.30%, the 30-year T-bond yield is up from 4.72% on Oct. 5. The one-year T-bill yield, while easing to 4.48% Tuesday, is up from 3.85% on Oct. 16.
The rise in T-bond yields is a big reason why mortgage rates hit a three-month high last week.
A key problem for T-bonds, according to bond market strategist James Bianco of Bianco Research in Barrington, Ill., is that they can’t stand the renewed competition from stocks.
Bianco said he was “not surprised, but disappointed” by the Fed’s decision to cut rates again Tuesday. He thought it would cause additional damage to the already fragile T-bond market by giving stocks another lift.
“If stocks are going to return 20%-plus for four years in a row, how can anybody stay in bonds?” Bianco asked.
And with the Fed uttering calming words about the economic outlook, the “flight to quality” that drove supersafe Treasury yields to their lowest points in October has dissipated.
Still, that’s also the good news: The rise in Treasury yields signals that things are better for the economy and its outlook.
Indeed, the “spread” between Treasury yields and yields on riskier corporate bonds has at least narrowed since early October, as corporate bond yields have declined--which the Fed says signals a thawing of the extreme risk aversion investors were displaying in September and early October.
“Spreads are still wider than normal, but this will help,” DeRose said of Tuesday’s rate cut. In other words, even if Treasury yields (and perhaps mortgage rates) don’t decline from here, there’s room for other important interest rates to come down.
From the stock market’s point of view, even if the Fed isn’t planning to cut rates further, stock investors may be more comforted by the return of normalcy in financial markets than worried about the idea that short-term interest rates may be leveling off, analysts say.
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The Fed Cuts Again
The Federal Reserve on Tuesday cut its benchmark short-term interest rate, the federal funds rate, to 4.75% from 5%, the third reduction since Sept. 29. But yields on Treasury securities, which often anticipate Fed moves, actually have risen in recent weeks--which may indicate the market doesn’t expect many more Fed cuts ahead. The federal funds rate, and yields on 1-year and 30-year Treasury securities, since midyear:
30-year Treasury bond: 5.30%
Fed funds rate: 4.75%
1-year Treasury bill: 4.48%
Source: Bloomberg News
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Other Interest Rates: What Now?
Here’s a look at what’s happened in key market sectors since the Fed began lowering interest rates on Sept. 29, and what the latest cut may mean:
HIGHER-RISK BONDS
* What’s happened: Yields on long-term U.S. corporate bonds and on emerging-market countries’ bonds have come down from their peaks during the September-October crisis, but not necessarily dramatically. The yield on an index of U.S. junk bonds compiled by KDP Investment Advisors has eased to 9.82% now from 9.93% on Sept. 29 and 10.72% at its peak on Oct. 20.
But that yield was 8.5% in mid-July. The yield on an emerging-markets debt index compiled by J.P. Morgan is at 15.19% now, down from 16.85% on Sept. 29 and 21.76% at its Sept. 10 peak.
* The outlook: Many analysts say yields should recede further as more investors gain the confidence to return to these markets. But if global-recession worries return, all bets are off.
SHORT-TERM CDs, MONEY FUNDS
* What’s happened: When the Fed is cutting short-term rates, it’s a given that bank CD yields and money market fund yields will go down. RateGram says the average national one-year CD yield has fallen to 4.58% now from 4.92% on Sept. 29. The seven-day average annualized money market fund yield is at 4.73% now versus 5.10% on Sept. 29.
* The outlook: The Fed’s latest quarter-point cut will almost certainly depress money fund yields further. For CDs, however, the issue is how much the banks need to attract cash: If loan demand stays robust, some banks and thrifts may try to avoid cutting CD rates much more, analysts say, so they can hold on to the money for lending purposes. Also, the rebound in Treasury bill yields in recent weeks could put pressure on the banks to stay competitive with CD yields.
Source: Times research
GOING DOWN
The Federal Reserve Board cut interest rates for the third time this since September. A1
