Acid test looms for markets: rising interest rates
How much of an economic recovery can we stand?
With the Federal Reserve now looking serious about taking away some of the unprecedented support it has provided to the banking system and the economy, policymakers are posing a whole new set of challenges for financial markets.
Stocks, bonds, real estate and commodities all have fed off cheap credit for the last year, which is why even the hint of higher short-term interest rates could be unsettling for them.
But not so far: On Friday, U.S. markets were generally calm after the Fed late Thursday announced that it would raise the “discount rate” that banks pay for loans from the Fed to 0.75% from 0.50%.
The Dow Jones industrial average closed the day up 9.45 points to 10,402.35, its fourth straight gain. Treasury bond yields eased a bit.
Stocks have rebounded for the last two weeks, and Treasury bond yields have risen as well, as economic data increasingly have pointed to fading risk of a double-dip recession.
The Fed’s move with its discount rate was another endorsement of a sustained recovery, even though the increase was more symbolic than anything else. Few commercial banks are borrowing from the Fed these days.
More important, the discount rate isn’t a benchmark for short-term rates in general. The benchmark is the so-called federal funds rate, which the Fed has held between zero and 0.25% for the last year.
In their statement Thursday, Fed policymakers said the discount-rate boost was “not expected to lead to tighter financial conditions for households and businesses.” At least, not yet.
But the Fed knows that raising any interest rate gets people thinking that there’s more to come.
There are, of course, glaring reasons for Chairman Ben S. Bernanke and his peers to move slowly in lifting the cost of money. Start with near-10% unemployment nationally. Add in the fact that millions of consumers are struggling mightily to reduce the debt loads they piled up in the last decade. Then there is the housing market, which remains largely supported (some would say entirely supported) by federal aid in one form or another.
Still, we should be rooting for the federal funds rate to be at least modestly higher by year’s end. At near zero, that’s an economic-emergency-level interest rate. If the economic emergency is receding, we shouldn’t need near-zero rates anymore.
The question for investors is how a mind-set shift in expectations for short-term rates will play out in the markets. Here are some thoughts on stocks and bonds specifically:
* The stock market: On the whole, equity investors seem to be keeping faith with the idea of a sustainable economic recovery. The rally since March 9 has lifted the Standard & Poor’s 500 index 64%, and despite numerous short-term pullbacks, the market has yet to suffer a drop of more than 10% before the bulls regained control.
Wall Street got a fright in January as worries deepened that Greece’s government-debt crisis would spread across Europe. But the market has snapped back since Feb. 8, supported by a host of stronger-than-expected reports on the U.S. economy.
Conventional wisdom is that rising interest rates are bad for stocks. But the truth isn’t so cut and dried. If rates are rising in the context of a growing economy, the market can advance -- as it did in 1988, following the 1987 crash, and as it did from 2004 through 2006, to cite just two examples.
Barry Knapp, head of U.S. equity strategy at Barclays Capital in New York, figures stocks could take a hit in the near term on nervousness over the Fed. “But once you actually get to the rate hikes, I think the market will be OK,” he said.
A 1% federal funds rate at year’s end, in Knapp’s view, would be a welcome sign for the economy and the market.
The glass-half-empty perspective is that the stock market has been running out of gas since October and that the economy will run out soon as well.
Stephen Roach, Morgan Stanley’s veteran economist and head of its Asian arm, believes that U.S. consumers don’t have the wherewithal to sustain spending at more than an “anemic” rate, and that exports and business capital spending can’t do enough to make up for individuals’ shortfall.
“The consumer is going to remain weak for years to come,” Roach asserts, echoing a common refrain of stock market bears.
If you expect the economy to struggle after its initial rebound last year from the Great Recession, Roach says, it’s hard to imagine higher interest rates registering as a positive for the stock market -- even though he believes the Fed would be right to start tightening.
* The bond market: Individual investors have fallen in love with bonds over the last year and have shoveled record sums into mutual funds that own fixed-income securities.
Could the Fed ruin this affair by raising short-term rates, or could it make bonds even more appealing? Maybe both.
Let’s say the bond market believes that the economy will continue to recover and that the Fed will start lifting the federal funds rate sometime this year.
Any corresponding increase in longer-term interest rates would devalue existing fixed-rate bonds, which could mean principal losses for bond investors (at least on paper).
But given where longer-term bond yields are now -- 4.7% on 30-year Treasury bonds, for example -- the market already has been pricing in some level of increase in short-term rates. That raises the question of how much longer-term yields would rise from current levels.
Jim Bianco, head of Bianco Research in Chicago, says that if the Fed were to be aggressive about tightening credit -- and draining away the huge amount of potentially inflationary money sloshing around the banking system -- long-term bond yields could fall even as short-term rates rose, because investors would lose any fear of rising inflation eating away at their bond returns.
But Bianco thinks it’s more likely that the Fed will be too slow to tighten, given the political pressure it will face to keep the economic recovery going. If inflation fears rise (still a big if) while the Fed dawdles, professional bond investors could sharply drive up long-term yields, he says.
Then what? If the recovery is as tenuous as its doubters say, any jump in yields on bonds, mortgages and other longer-term, fixed-income investments could cause the economy to stall -- which, in turn, could give way to another drop in interest rates.
In the meantime, income-hungry investors would have had an opportunity to grab bonds at more attractive yields, just as many did early in 2009.
Of course, things could get much more complicated for bond investors depending on other issues, including the market’s ability to absorb record amounts of new Treasury debt.
But David Rosenberg, chief economist at investment firm Gluskin Sheff & Associates in Toronto, thinks individuals’ demand for bonds is a trend that isn’t close to peaking, as aging baby boomers increasingly hunt for income-producing investments on which to live in retirement.
Investors, Rosenberg adds, should be prepared for wilder swings in all markets that will be nerve-racking but also will present opportunities.
“Intense volatility in markets and the economy is typical [after] a credit collapse,” he says. And we have just lived through a credit collapse for the ages.
