Will Strong Growth Trump Higher Rates?

Optimism about the growing economy has lifted some major U.S. stock indexes to record highs in recent weeks. But the market now is threatened by an old fear that’s back to haunt again: Could economic strength become too much of a good thing?

The government reported Friday that a net 207,000 jobs were created in July, a solid showing that affirmed the health of the economic expansion this summer. Other recent data also have been upbeat, and second-quarter corporate earnings reports have mostly been a pleasant surprise for investors.

All of this helped to drive up stock prices last month and stoke hopes about the longevity of the current bull market, which will be 3 years old in October.

But the rally stalled late last week, and stocks ended broadly lower Friday after the employment report. The problem: Good news about the economy is having the usual effect on interest rates -- pushing them higher.

In the Treasury bond market, shorter-term yields hit four-year highs Friday, and the bellwether long-term yield on the 10-year Treasury note rose to 4.39%, up from 4.31% on Thursday and the highest since April 11.

Federal Reserve policymakers will meet Tuesday and are virtually certain to raise their benchmark short-term rate, the so-called federal funds rate, from 3.25% to 3.5%. It would be the Fed’s 10th rate increase since June 2004.

The jump in job creation in July added “supporting evidence that the Federal Reserve will continue to increase interest rates for the rest of the year,” said Eugenio Aleman, senior economist at Wells Fargo & Co. in Minneapolis.

A popular theme on Wall Street for much of this year has been that the Fed would pause in its credit-tightening campaign, giving both the stock market and the bond market a break.

But the economy’s strength suggests that “Fed officials are probably boosting their estimate of how far the funds rate ultimately needs to rise,” Goldman Sachs & Co. economists warned clients in a note on Friday.

To many stock market bulls, this is a nice problem to have.

“I think the employment report is good news for stocks,” said Ed Keon, investment strategist at Prudential Equity Group in New York. He reasons that a healthy economy bodes well for corporate earnings growth in the second half of the year, which could underpin share prices.

Instead of slowing, “it looks as though profits may actually accelerate in the second half,” Keon said.

One driver of earnings should be the restocking of business inventories that were depleted in the second quarter, said Joseph Carson, an economist at Alliance Capital Management in New York.

The government estimates that the economy grew at a real annualized rate of 3.4% last quarter. The rate would have been faster if businesses hadn’t allowed inventories to decline, Carson said.

It appears that many companies were expecting a moderate pace of demand from consumers and other businesses, and were “blindsided by the strength in sales” in the spring, Carson said. By restocking in the current quarter, the corporate sector should help spur the economy to a hefty 4.2% growth rate in the period, he said.

For most of July, stock investors seemed thrilled by the economic data and by second-quarter earnings reports. With 80% of the companies in the blue-chip Standard & Poor’s 500 index having reported quarterly results, operating earnings for the index are on track for a year-over-year gain of 11.5%, according to research firm Thomson Financial in Boston.

Even in the face of rising short- and long-term interest rates -- and record oil prices -- the equity market overall in July turned in its best performance of any month this year. The S&P; 500 gained 3.6%; the technology-heavy Nasdaq composite surged 6.2%.

“Finally, the market has responded to earnings!” Mike Thompson, director of research at Thomson Financial, wrote in a report a week ago.

Stocks continued to rally into the first half of last week, lifting the S&P; 500 and the Nasdaq index to four-year highs, and the New York Stock Exchange composite index and S&P; small-stock and mid-size stock indexes to all-time highs.

But most stocks pulled back on Thursday and Friday. The losses were relatively modest, but they raised concern that investors were beginning to focus on economic growth as a negative for the market because of the effect on interest rates.

Peter Boockvar, investment strategist at Miller, Tabak & Co. in New York, believes that investors have good reason to fear higher rates. The U.S. economy, in his view, is heavily dependent on low interest rates, in large part because cheap money has fueled the booming housing market, which in turn has supported consumer spending as people have tapped their soaring home equity.

The risk now is that rising rates could cause trouble for the economy much faster than investors might expect, Boockvar said, if the housing market were to slow substantially.

In the stock market, the hope that stronger earnings growth can trump rising interest rates is “playing chicken with the Fed,” he said.

Besides threatening consumer spending, higher rates pose another challenge to stocks by making fixed-income instruments, including bonds and bank savings certificates, more competitive as alternatives to equities.

Because there is little question that the Fed will continue to raise short-term rates, some analysts say the fate of the stock market’s summer rally may rest with long-term rates, which the central bank doesn’t directly control.

At 4.39% on Friday, the 10-year Treasury note yield was up from 3.9% in late June, but still within the range of 4% to 4.5% that has prevailed for most of the last two years.

Economists have offered plenty of reasons investors have kept long-term rates tame since 2003, including that a global savings glut has translated into heavy competition to lock in long-term yields.

Some analysts also say low bond yields reflect investors’ collective belief that economic growth, and inflation, are more likely to slow in the years ahead than speed up.

In any case, the biggest test for long-term rates now looms: As the Fed further pushes up short-term rates amid a revving economy, will bond investors be willing to accept the same skinny yields, or will they demand significantly more?

A sharp jump in long-term rates could reinforce the stock market’s fears about faster economic growth being a bad thing rather than a good thing.

If long-term rates remain restrained, by contrast, they might give equity investors more confidence to bet that a growing economy and rising corporate earnings mean share prices have further to run.