Talk about an anticlimax. Alan Greenspan hints that he's primed to raise interest rates, and the financial community goes into a frenzy of speculation about when, why and how bad. But when the Federal Reserve finally pulls the trigger, the previously terrified markets throw a party.
Which might lead a reasonable person to see the whole process as one of those insider things with more relevance to pundit prestige than to the average stock portfolio. Well, maybe, maybe not. There are two ways of reading the Fed's action, one benign, the other as a sign of bad things to come.
But first, let's set the stage and define some terms. The Federal Reserve Board, or Fed, is the agency charged with policing the banking system and maintaining the value of the currency (i.e., keeping inflation close to zero). Its decision-making body is the
Federal Open Market Committee
, made up of 12 solid-citizen bankers and economists, and chaired by Greenspan. Its main tool is the
fed funds rate
, the interest rate banks charge one another for overnight deposits. Because business loans and adjustable-rate mortgages move more or less in step with fed funds, it's a powerful tool for controlling the supply of money, the raw material of economic growth.
Problem is, there's a long, variable time lag between changes in the money supply and changes in the economy. So the Fed and, therefore, the Street never know exactly where they stand (hence the big bucks paid to "Fed watchers," who spend their days trying to read Greenspan's mind).
This week's debate has its roots in what looked, a year ago, like a for-real global financial collapse. Developing Asian economies were imploding, Japan was teetering, and who knew what was going on in Russia. Then
Long-Term Capital Management
, a big hedge fund with ties to several major banks, collapsed, threatening to pull down the whole house. The Fed responded by cutting interest rates and flooding the global economy with "liquidity," i.e., ready cash, which seems to have saved the day. The developing countries survived and the U.S. boomed. And all that extra liquidity poured into large-cap growth stocks (which were seen as safe and predictable in an otherwise uncertain world) and Internet start-ups (authors of the most exciting stories that investors had ever seen).
Now that the world is -- financially, at least -- a safer place, the rationale for all this extra money has disappeared, and the Fed is looking for ways to soak it up.
Which brings us back to the impact of all this on stocks: A quarter-point bump in short-term rates means nothing if it's just a one-shot deal. But if it's the first in a long parade of increases, then stock investors have a big problem. The two scenarios play out like this:
No Big Deal, Let the Good Times Roll
The Internet is forcing prices down everywhere. And now that capital is free to flow wherever it wants, U.S. workers can't press for higher wages. Meanwhile, long-term interest rates have already risen from last year's low of 4.7% to more than 6%, which will slow the economy without the Fed's help. Inflation, in short, ain't coming back, and economic growth can continue at a reasonable rate for years. Ditto for corporate profits and stock prices.
In a recent interview,
market strategist Abby Joseph Cohen called a quarter-point rate hike a "flu shot," similar to the quarter-point rise in early 1997 that preceded two of the best years in U.S. history. If she's right, then risk is still rewarding: Cyclical stocks like airlines, railroads and semiconductors, which thrive in boom times, will be hot. And the large-cap growth stocks that have led the market lately might still have legs. Or ...
The Beginning of the End
The easy money of the past few years was an aberration brought on by the international financial collapse, and no way will the Fed let it continue. The one-shot tightening in 1997 was also an aberration: Once "Mr. Gradualism," as
Wheat First Union
strategist Don Hays calls Greenspan, starts something, he usually keeps at it. In the year after February 1994, for example, the Fed raised interest rates six straight times.
Hays calculates that the
is overvalued by more than 30% vs. 10-year Treasuries, which makes bonds a good place to be, since tighter money will choke off any hint of inflation. High-yield stocks like utilities and real estate investment trusts, or REITs, might also be safe havens, while some "value" plays that haven't yet had a big run might outperform.
But let's be clear. No one knows for sure what happens next. The Fed has now adopted a neutral bias toward future rate hikes, a signal that the status quo will prevail for now. Meanwhile, the Fed will see what the economy does, debate the results and drop a lot of hints before it makes one of the above scenarios a reality. Here are some of the indicators that Greenspan & Co. will be watching.
- Productivity. This is the value of what the average worker produces per hour, and a key to how fast the economy can grow without inflation. Lately, productivity has been rising at a 2.5% annual rate, which means that wages can go up by a like amount with no inflation, or by 3.5% with only 1% inflation. (See the
Bureau of Labor Statistics'
economy at a glance page.)
Bonds. Long-term corporate and Treasury bonds generally trade on inflationary expectations. So the recent jump in bond rates is a sign of inflation anxiety, but also (since higher interest rates slow economic growth) a potential cure for it. Going forward, if bond buyers decide inflation isn't a problem, long-term rates will fall. If not, then the imbalance between stock and bond valuations will increase the chance of a bear market in stocks.
The dollar. When the dollar goes up vs. other currencies, U.S. goods become more expensive on world markets, slowing the domestic economy and lessening the odds of higher interest rates.
Commodity prices. Higher prices for things like gold, copper and aluminum imply a strengthening global economy and rising interest rates. (See the
Commodity Research Bureau
Money supply. Years ago, this was the king of indicators. Then the information economy muddied the definition of money, making it one of those in-the-eye-of-the-beholder things that give market strategists job security. But the Fed does set targets for money supply growth, and, assuming no more global crises, will probably pay them some mind. The current target for
M2, a broad measure of money, is 3%. (See the Fed's
economic statistics Web page.)
John Rubino, a former equity and bond analyst, writes a column on mutual funds for POV and is a frequent contributor to Individual Investor, Your Money and Consumers Digest. His first book, Main Street, Not Wall Street, was published by William Morrow in 1998. At time of publication, he had no position in any stocks mentioned. While Rubino cannot provide investment advice or recommendations, he invites your feedback at