To Wall St., Economy’s Recovery Is a Done Deal

What happened to the economic slowdown/slump/recession?

Increasingly, financial markets are choosing to view the “ailing economy” in the past tense. The betting is that a recovery is next up--which the stock market, not surprisingly, thinks is just great, while the bond market is filled with dread.

The action in the markets over the last few weeks will have to figure prominently in the discussions Federal Reserve policymakers have when they meet Tuesday.

Until late last week economists were nearly unanimous in the belief that Fed Chairman Alan Greenspan and his peers would vote Tuesday to cut the central bank’s key short-term interest rate to 4% from 4.5%, the fifth reduction this year.

By Friday, however, Wall Street was engaged in serious second-guessing. First came the government’s report Thursday that new claims for jobless benefits spiked downward the previous week, suggesting that more laid-off workers were finding jobs.

On Friday, two more reports pointed to surprising economic strength: The government said retail sales in April were much better than expected, and the University of Michigan’s monthly consumer survey showed a jump in confidence in May, after a long slide.

In the Treasury bond market, where good news for the economy usually translates into bad news for interest rates, traders began bailing out of bonds as soon as they got to their desks Friday morning.

By day’s end the yield on the benchmark 10-year Treasury note had shot to 5.45%, up from 5.29% Thursday and the highest since early December.

The bond market’s not-so-subtle threat to the Fed reads something like this: “You’ve probably done enough already, cutting short-term interest rates two percentage points since Jan. 3. The economy will be fine. If you continue to reduce short rates, we may keep pushing long-term yields higher because we’re more concerned about a new economic boom and inflation pressures.”

There’s also another way to read the bond market’s turnaround: Some traders are betting that the Fed now knows it won’t need to cut rates much more. If the Fed’s credit-easing cycle is over, then the market naturally will turn to focusing on the next cycle--meaning the potential for the central bank to start tightening credit again somewhere down the road.

The message of both the bond market and the stock market has been one of economic recovery for the last six weeks.

It wasn’t a coincidence that the Dow Jones industrial average and the 10-year T-note yield both bottomed on March 22--the Dow at 9,389.48, the T-note yield at 4.76%.

Since then the Dow has rebounded 15.2%, while the T-note yield has surged 0.69 percentage point, driving the security’s price down 5.8%.

Stock investors see the bright side of an improving economy, which is that consumers and businesses will buy more goods and services, fueling a recovery in depressed corporate profits.

Bond investors see the dark side of a better economy: Demand for money will rise, thus putting upward pressure on the cost of credit (interest rates). If you just bought a fixed-rate bond two months ago, you don’t relish the thought that new bonds could be paying substantially more by the end of the year. You feel snookered.

It also follows that those investors who are willing to buy bonds now will demand higher yields if they figure the economy’s next turn is up rather than down.

Of course, markets don’t always guess right about the economy’s direction. Someone who just lost his or her job last week may well wonder, “What recovery?”

Still, the bond market was quite prescient last year. Long-term yields began to dive by late summer, foreshadowing the steep slowdown in corporate spending that took many economists by surprise by year’s end.

Now bond investors think the weight of the evidence says the economy will avoid recession in the near term, and that it could be rebounding by the fourth quarter.

Another event late last week added to many investors’ confidence about a recovery: The European Central Bank cut its key short-term lending rate for the first time in two years. That means the Fed, the European bank and the Bank of Japan all are in sync on monetary policy, working to keep the world out of recession.

What’s more, still on the horizon is the Bush administration’s planned tax cut, a big dose of fiscal stimulus for the economy.

James Bianco, whose Bianco Research in Barrington, Ill., is well known for its data on bond market trends, says many bond investors are coming to believe that Greenspan wants to avoid a recession at all costs--even if one major cost turns out to be higher inflation.

Bianco notes that the Fed, in its last two rate cuts, said virtually nothing about maintaining an inflation-fighting policy--even though inflation has been rising since 1999.

“They aren’t even paying lip service to the idea that inflation is under control,” Bianco said.

Bond investors, who fear inflation more than any other threat (because inflation erodes the fixed returns on bonds), may have been willing to give the Fed the benefit of the inflation doubt earlier this year, when the odds seemed high that the economy could topple into recession.

Now, with that threat seemingly evaporating, inflation is back as Topic A for many bond investors.

Could the market be overreacting? It wouldn’t be the first time.

“Our view is that the economy is weaker than most people think,” said G. David MacEwen, newly named chief investment officer for fixed-income at American Century Funds in Mountain View, Calif.

David Jones, economist at bond dealer Aubrey G. Lanston in New York, argues that the risks to the U.S. economy are “still tilted to the downside,” given rising layoffs, continued reluctance by many firms to spend on technology, and slowdowns in Japan and Europe.

But does the Fed, in the wake of its most aggressive credit-easing campaign in decades, need to cut rates much more to ensure an economic recovery? Or should Greenspan simply wait for the cuts of the last four months to take effect?

One option, Jones said, is for the Fed to cut another half-point Tuesday, but also to declare that it has moved to a “neutral” stance on rates--meaning there may not be more cuts after this one.

If the Fed goes that route, it will surely test stock investors’ conviction. Many equity investors may have been counting on a series of rate cuts through summer to justify buying stocks at what are arguably still-high valuations, even after the plunge of the last year.

On Friday the stock market still seemed stoic: The Dow lost 0.8% to 10,821.31, and the Nasdaq composite fell 1% to 2,107.43, but that was minor damage considering the magnitude of the jump in bond yields, analysts noted.

How the bond market will take the Fed’s decision Tuesday--whatever that decision turns out to be--is anyone’s guess.

Some bond market pros say the problem for the Treasury market, in particular, is that speculators were running wild there in recent months. As yields fell, driving bond prices higher, traders piled on.

“Where did the bubble go after technology? I think it went to the Treasury market,” said Tom Sowanick, fixed-income strategist at Merrill Lynch & Co. in New York.

If that bubble is bursting, and yields continue to surge, the question is whether they will threaten any economic recovery underway.

The optimistic view is that yields remain far below their late-1999 peaks, and that many investors (as opposed to traders) could soon be enticed to buy.

Interestingly, the Treasury market’s woes haven’t been reflected much in the corporate bond market. Indeed, buyers flocked last week to the biggest U.S. corporate bond sale ever, WorldCom’s $11.9-billion issue.

But heavy corporate bond issuance this year also raises a flag: Are companies rushing to lock in yields on debt because they expect that the cost of money will only get more expensive if they wait?

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Tom Petruno can be reached at tom.petruno@latimes.com.