After the High, Will Landing Be Soft?
On Wall Street, a lot of bets already have been placed on the likelihood of a soft landing for the economy.
Now comes the test of investors’ convictions.
In the next few months, it should become much clearer just how much the U.S. economy has slowed, how much trouble the housing market faces, whether inflation is truly ebbing and how well corporate earnings are holding up.
All of that will largely determine the Federal Reserve’s next move with short-term interest rates: stay on hold, start raising them again or begin a round of cuts.
The Fed’s course will help determine whether the stock market’s momentum -- which sent the Dow Jones industrial average into record territory last week -- will continue through the end of the year.
Stock investors have come to regard a fourth-quarter rally as nearly a sure thing, and there is plenty of faith among them that this year won’t defy the historical trend.
Stock and bond markets in recent months have been in a zone of relative contentment, abetted by the Fed’s decision Aug. 8 to pause after raising rates consistently for two years. It has also helped that oil prices have tumbled to less than $60 a barrel.
Long-term Treasury bond yields hit seven-month lows in late September, and last week the Dow finally recouped the last of its losses from the 2000-02 bear market.
David Rosenberg, an economist at Merrill Lynch & Co., aptly describes this period as the “initial sugar high” that typically accompanies the halt of a Fed credit-tightening cycle.
But on Friday, the government’s report on September employment trends upset the bond market’s mellow mood. Although the economy added just 51,000 net new jobs last month, the August payroll gain was revised up to 188,000 jobs from the originally reported 128,000.
Moreover, the national unemployment rate fell to 4.6% from 4.7% in August. “The labor market got tighter last month,” said Allen Sinai, head of Decision Economics Inc. in New York.
That raised questions about whether the economy is slowing enough to keep the Fed on hold.
Nervous traders drove the yield on the benchmark 10-year Treasury note to 4.70% on Friday, up from 4.61% on Thursday and the highest since Sept. 20.
That’s not a big deal in the context of the plunge in the T-note yield from 5.24% in late June. But a few more reports that suggest the economy is faring better than expected, and the soft-landing scenario -- slow but decent growth, declining inflation and no more Fed rate hikes -- might suddenly face serious doubts.
Indeed, some Fed policymakers have warned in recent speeches that the central bank may have to tighten credit further to finish the job of containing inflation.
The Fed’s preferred inflation gauge rose 2.5% during the 12 months ended in August. Policymakers want that figure back under 2%.
Charles Plosser, president of the Fed’s Philadelphia bank, said last week that the central bank needed to “remain vigilant and recognize that maintaining the current stance of policy, or even firming further, may be in the best interests of the economy’s long-run performance.”
Sinai believes that the economy hasn’t weakened much, outside of residential real estate. “The job market is quite good, and [workers] aren’t having trouble finding jobs,” he said.
The Fed, he said, “probably would prefer to raise rates some more, except for housing.”
Even so, he thinks the most likely scenario is that the central bank will stay on hold with its key rate at 5.25%, betting that the economy will slow meaningfully in 2007.
Jeffrey Kleintop, chief strategist at money manager PNC Advisors in Philadelphia, also is in the soft-landing camp. He is so optimistic that inflation will diminish, he’s predicting that the Fed will cut its key rate four times in 2007 while the economy grows at a moderate pace of about 2.5% (after adjusting for inflation).
If he’s on the mark, Wall Street should be jubilant. He expects the blue-chip Standard & Poor’s 500 index to reach 1,500 by the end of 2007, which would be an 11% gain from its current level.
The stock market certainly looks like it wants to go higher. It largely held its ground Friday even as bond yields backed up. The Dow eased 16.48 points, or 0.1%, to 11,850.21, after reaching a third consecutive record high on Thursday. Most broader indexes were likewise down modestly.
The Dow is up 10.6% year to date, putting it on track for its first double-digit gain since 2003.
The bulls also remain in control in Europe, even though interest rates haven’t stopped rising there.
The European Central Bank raised its benchmark rate from 3% to 3.25% on Thursday. But a Bloomberg News index of 500 European blue-chip stocks has rebounded from the sell-off that sapped global markets in the spring, and closed Friday at 247.35 -- just below its five-year high reached in early May. It’s up 11.3% this year.
There’s a big reason many investors are confident about a U.S. soft landing and another phase for the stock bull market that began four years ago this week: That was their experience in the 1980s and the 1990s.
The bull market that began in 1982 stalled in 1984 as the Fed tightened credit. That gave way to a soft landing, then a rebound in growth and a stock surge from 1985 to 1987.
Likewise, the Fed tightened in 1994, clipping the bull market that began late in 1990. As a soft landing unfolded in 1995, stocks were off to the races again.
Is the Fed on the verge of a hat trick? A lot of money is betting that it is. And as in 1985 and 1995, there’s undoubtedly plenty more on the sidelines that could flow into stocks and bonds if the Fed gets it right.
