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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 percent from 0.50 percent.
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 past 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 percent 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 percent 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
percent, and despite numerous short-term pullbacks, the
market has yet to suffer a drop of more than 10 percent
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
percent 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 percent 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.
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