Rates Start to Weigh on Investors

The Federal Reserve’s job only gets tougher from here. Which explains a lot about the recent turmoil in global financial markets.

The Fed has been raising its benchmark short-term interest rate since June, when the rate was at a generational low of 1%. Everyone knew that was an emergency level for an economy no longer facing an emergency. So a series of six quarter-point rate hikes didn’t surprise anyone.

Last week brought No. 7, which put the Fed’s rate at 2.75%. That was no shocker either. But the Fed’s post-meeting statement did give Wall Street a jolt.

Chairman Alan Greenspan and peers used the statement to issue an inflation warning, the first since 2000. “Pressures on inflation have picked up in recent months,” the Fed said. In a five-paragraph statement mostly filled with boilerplate, those nine words obviously were carefully chosen; they were meant to send a message.

But what’s the message? The Fed, as usual, wants to leave some things to Wall Street’s collective imagination.

The central bank could be saying that it may begin raising rates at a faster pace than quarter-point increments, to slow the economy and brake inflation. Or, to that same end, it could be saying that rates ultimately may go higher than what many people have been expecting.

Or the Fed could be jawboning the financial markets -- trying to frighten long-term interest rates up, for example, and to scare currency traders away from pushing the dollar lower. A rise in bond yields could slow the economy, particularly the housing sector. If the dollar’s long slide is halted, the upward trend in import prices could end.

Even if Greenspan wanted to tell the nation exactly what he planned to do, he couldn’t -- because the Fed has no way of knowing how high inflation might go.

Thanks in large part to soaring oil prices, the U.S. consumer price index was up 3% over the last 12 months. That’s hardly a disaster. If financial markets started worrying about 4% or 5%, however, the story would become much more troubling. The Fed last week wanted to show that it was vigilant and would do whatever was necessary to damp inflation.

Investors, who generally fear inflation because it erodes the value of financial assets, appreciate the Fed’s concern. Then why have markets slumped the last three weeks? It may be sinking in that the easy part of the central bank’s credit-tightening campaign is over. The next phase of rate increases is likely to have a much more profound effect on the global economy than the phase that took the Fed’s rate from 1% to 2.75%.

If the Fed raises rates too much from here, it runs the risk of global recession. If it doesn’t raise rates enough, inflationary forces could get the upper hand.

For central bankers, these risks are the same as always. But after three years of extraordinarily low credit costs worldwide, investors are being reminded that bad things can happen when interest rates, or inflation, or both, are rising.

Hence, stocks have weakened around the globe since early March, leaving most categories of stock mutual funds in the red this year. Bonds too have lost value as long-term interest rates have risen, depressing the prices of older fixed-rate securities.

Investors are repricing stocks and bonds to account for new risks -- for example, that tighter credit could cause ugly financial blowups among heavy debtors around the globe. That debtor list includes some governments, companies and individuals.

Many Wall Street pros say markets have been overdue for a risk reassessment. Greenspan himself in February spoke of a “conundrum”: Why, he wondered, were investors willing to accept such relatively low yields on long-term bonds at a time when the Fed was pushing short-term rates higher and signaling that there was more to come?

One answer is that there is a huge sum of money sloshing around in this nearly all-capitalist world, and not enough attractive places for it to go.

“Globally, we’ve got excess capital seeking too few returns,” said Eric Hiller, chief interest rate strategist at Bank of America in Chicago.

If that excess capital doesn’t disappear soon, it could guarantee that the current pullbacks in financial markets will be short-lived -- just “corrections” that allow investors to get in at better prices, before the next run-up.

Real estate investment trust shares have taken a hard hit this year, in part because of fears that higher interest rates will hurt the property market. The average REIT stock mutual fund is down 7.3% since Jan. 1.

REIT shares also fell sharply last spring. That sell-off ran its course in just six weeks before buyers poured back in.

One tip: Investors who like the long-term outlook for emerging-market stocks and bonds might want to hope that the recent selling in those markets continues for a while, to afford an entry point similar to what REIT buyers got a year ago. Mexico’s stock market, one of the world’s hottest last year, is down 7.4% since March 7.

What about U.S. bonds in a rising rate environment? Bill Gross, the Newport Beach-based bond guru at Pimco mutual funds, said he thought a fair yield on the 10-year Treasury note would be about 5.5%, compared with the 4.59% the notes yielded as of Friday.

But Gross said he was forced to temper his expectations for how high the T-note yield might go because foreign investors, such as the Bank of Japan, have been willing to buy at yields even well below current levels.

For people who are unwilling to take a chance on stocks or bonds as interest rates -- and risks -- increase, the good news from the Fed’s statement last week was that returns on cash accounts, such as T-bills and bank savings certificates, will only get better.

Cash may not be the best place for investors’ money in the long run, but those who have it may feel a lot better these days than those who don’t.

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

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Tough start for 2005

Here are the year-to-date average total returns for major categories of stock mutual funds and bond mutual funds:

*--* Stock funds Natural resources 11.40% European 1.2% Emerging markets 0.9% Large-cap value -1.6% Small-cap value -2% Large-cap growth -4.8% Small-cap growth -4.8% Gold -5% Real estate -7.3% Technology -9.4% Bond funds Long-term government -0.9% High-grade corporate -0.9% Short/intermediate-term govt. -0.9% Corporate junk -0.9% Emerging markets -2.1% International -2.6%

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Sources: Morningstar Inc., Lipper/Reuters

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