Rate Pause Likely -- but Then What?

Unless Federal Reserve policymakers want to risk triggering the equivalent of a major earthquake in global financial markets Tuesday, they will finally halt their two-year-long credit-tightening campaign.

But the glee that the idea of a Fed pause generated in the U.S. stock market say, three months ago, is missing now. Many investors seem fearful that the central bank has gone too far with interest rates.

By contrast, Treasury bond traders can barely contain their joy. Those who have been predicting for the last year or more that the Fed was finished -- a consistently wrong bet -- have a chance to be right, just like the proverbial stopped clock.

Confidence about a Fed pause was cemented Friday, after the government said the economy created a meager net 113,000 jobs in July.

That report was consistent with other data in recent weeks that have pointed to an economic slowdown, which is what Wall Street has assumed would be a precondition for an end to Fed interest-rate hikes.

By Friday afternoon, 17 of 22 major Treasury bond dealers polled by Reuters were telling their investor clients that the central bank would hold its benchmark short-term rate steady at 5.25% when policymakers gather Tuesday.

It would be the first Fed meeting without a rate increase since May 2004. Just think: There are 2-year-old kids out there who have never known what it’s like to live in a time of stable short-term rates.

The employment report, and the likelihood of the Fed pausing, fueled a rush of buying in longer-term Treasury securities Friday as some investors sought to lock in yields.

The yield on the 10-year Treasury note sank to a four-month low of 4.89%, down from 4.96% on Thursday and a drop of 0.35 point from the peak of 5.24% reached on June 28, the day before the last Fed rate increase.

Even some die-hard bond bears who have been forecasting higher interest rates were forced to fold their tents Friday.

Michael Darda, an economist at investment firm MKM Partners in Greenwich, Conn., who has accurately called the Fed’s course for the last year -- and who had expected more rate hikes -- said the jobs report gave the central bank “enough ammunition to temporarily suspend its tightening campaign.”

With most of Wall Street now anticipating no action Tuesday, Fed Chairman Ben S. Bernanke is painted into a corner: Even if he and his cohorts believe they could justify another rate increase because of well-documented inflation pressures in the economy, such a move could shock financial markets. And the Fed generally prefers not to use a Taser on investors.

There still is the possibility that Bernanke could seek to lift rates one more time and then use the Fed’s post-meeting statement to declare that, at least for the moment, they’re done.

That’s the view of Goldman, Sachs & Co.’s economics team. “We think the balance still tilts in the direction of one more rate hike for the road,” Goldman said in a report Friday.

For investors, whether the Fed pauses at 5.25% or 5.5% may make little difference. What’s important is whether interest rates actually are peaking for this economic cycle, or whether a pause will give way to more rate hikes later this year or in 2007.

The hunger for longer-term bonds in recent weeks suggests that many investors (or traders, anyway) believe that rates have crested for good. But then, some also thought the same in the summer of 2004, the spring of 2005, last fall and again in May. They were too early every time.

Some investment pros don’t see the appeal of a 10-year T-note paying less than 5% in annual interest. “It’s not a very compelling value,” said Art Micheletti, portfolio manager at Bailard Inc., a Foster City, Calif.-based investment firm.

One way to look at the bond situation: If the Fed holds its short-term rate at 5.25% for at least the next few months, how much lower can long-term yields go, given that they’re already below the Fed’s rate?

Normally, long-term interest rates are higher than short-term rates, to compensate for the risk. When long rates fall below short rates, it’s usually a signal that: 1) investors expect the Fed to start cutting short rates soon or 2) investors believe the economy is headed for recession. Or both.

Jeffrey Gundlach, chief investment officer at investment giant TCW Group in Los Angeles, thinks the Treasury market could rally significantly even from these levels, driving long-term yields lower. “It wouldn’t surprise me to see a 4.5% yield on the 10-year T-note,” he said.

The economy is being weighed down by near-record oil prices and by the softening housing market, Gundlach says. “If oil prices spike again, that could be the last straw,” he said.

On the other hand, how many times in the last two years have economists counted out U.S. consumers, figuring they were down to their last penny? July sales at major retailers, reported late last week, were better than many economists had projected ... once again.

However, the U.S. economy may be facing another challenge to growth: weaker business spending.

Joseph Carson, economist at money manager AllianceBernstein in New York, says one of the biggest surprises in the government’s second-quarter economic growth report on July 28 was that business spending on equipment and software declined at a 1% annualized rate in the quarter, the first drop in three years.

Why was that number so soft, given that many companies are flush with cash and earnings of blue-chip companies overall still are rising at a double-digit percentage rate? The obvious conclusion, Carson said, is that “businesses are becoming more hesitant to spend because they’re worried about the U.S. economic outlook.”

The stock market clearly is on edge. Major market indexes hit multiyear or all-time highs early in May in part on the expectation that the Fed was done tightening credit. When it became clear that the Fed had further to go, stocks tumbled worldwide from mid-May to mid-June.

Now, despite widespread belief that a Fed pause is a certainty, the market remains well below its spring highs. On Friday, the Dow Jones industrial average rallied as much as 100 points at the start of trading as Treasury bond yields plunged on news of the weak July employment data. But the Dow then slumped to finish off 2.24 points at 11,240.35.

Even as the market has rebounded in recent weeks, many investors have been playing defense -- meaning, they’ve favored shares of companies whose sales and earnings would be expected to hold up reasonably well in a downshifting economy.

Utilities are classic defensive plays. The Dow utility stock index hit a record high last week.

On the flip side, the Dow transportation stock index has fallen for five straight weeks, and is down 12.4% from its record high reached on May 9. The transportation business often provides an early warning of the economy’s turns.

Still, many market pros say it’s too soon to get overly bearish about U.S. stocks, or overly bullish about bonds. We may yet find out that the Goldilocks scenario -- an economy that’s neither too hot nor too cold but just right -- remains achievable. Stranger things have happened.

David Rosenberg, an economist at Merrill Lynch & Co. who has been too early for the last year calling for a peak in interest rates, is far more confident now, naturally. But even he admits that the Fed will need much more evidence of a slowing economy just to guarantee that its tightening cycle is over, let alone before it begins lowering interest rates.

What may be telling is if long-term interest rates continue to slide in coming months while the stock market stays flat or falls anew. That would be a strong signal that, as has so often happened historically, the Fed has indeed gone too far.

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