Fed Halt Could Hurt You

Hard Assets, Financial Stocks Will Rally

Investors aren't just looking at the end of a period of rising short-term interest rates; they're looking at the end of a period of extreme predictability. Month in, meeting out, we knew what the Fed was going to do: raise short-term rates by another 0.25 percentage points. We knew inflation was going to stay under control, at least officially.

Whatever comes next has to be less certain than that. Already, hard-asset, safe-haven stocks that profit from gold, copper, timber and oil have moved up in 2006 on just the suspicion of future inflation. Gold closed at $541.20 an ounce on Friday, up 4.6% for the week. It's up 30% since the end of 2003.

Financial stocks will do well, not because they're safe havens in times of uncertainty, but because the end of the Fed's policy of raising rates will take the pressure off their profit margins. Banks borrow short -- from depositors or in the short-term commercial paper markets -- and lend long. They make their profits out of the spread between short-term and long-term rates. The collapse of the spread between short-term and long-term interest rates has cut into those profits.

The end of short-term rate hikes alone will help financial companies and their stocks, because no longer will the spread get smaller and smaller from month to month. A widening of the spread would be gravy for the sector, but it's not necessary for the sector to outperform in 2006.

Fed May Need to Cut Rates

The financial markets have come to rely on the godlike powers of the chairman of the Federal Reserve. With a tweak here and a polysyllable there, Alan Greenspan can tame inflation, goose growth, strengthen the dollar and -- after changing in the nearest phone booth -- fix liquidity crises with a single flood of cash. Or so the markets have come to believe.

The historical record, however, suggests that the Federal Reserve usually overshoots. It raises rates too much, and the economy starts to show signs of stalling. Or it cuts rates too much, and the financial markets show signs of an asset bubble. The odds, after what are likely to be 15 interest rate hikes over almost two years, are that the Fed will overshoot in 2006, as well. As Bill Gross, the bond guru of Pacific Investment Management, notes in his most recent newsletter, the Federal Reserve often has to cut rates within six months of ending a series of interest rate increases.

No guarantees, of course. But this is exactly the kind of unexpected turn of events that consumers, mortgage-holders and investors ought to expect.