The Upside of More Fed Rate Hikes

Those hoping for a Fed pause, or an end to the rate hikes, should be careful what they wish for.
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The idea that the

Federal Reserve

was set to pause its tightening campaign helped fuel a relief rally in the stock market in the two weeks that followed Hurricane Katrina's hit to the Gulf Coast.

Then, as the market began rolling back its expectations of a Fed pause, it was hopes that governmental spending to rebuild the Gulf Coast would boost economic activity that fueled gains. But this enthusiasm faded last week amid concern over inflation -- from looser fiscal spending and high energy costs.

In this context, the reality of the Fed pause so many bulls are lobbying for may not be so desirable for equity investors, while another rate hike may prove to be quite beneficial.

Richard Bernstein, equity strategist at Merrill Lynch, says that the combination of tight (and tightening) monetary policy and looser fiscal policy has historically generated the highest six-month median returns of any policy combination, at 6.7%, and "normal" 12-month returns of 9.8%. (Bernstein notes that his research was based on actual fiscal spending, as opposed to spending plans.)

This would suggest the fairly simple idea that a fiscal spending boost to the economy can be beneficial for stocks as long as monetary policy keeps inflation contained.

A commitment to tighter monetary policy would theoretically put a floor under bond prices and a ceiling on yields. This helps counteract the expected impact of a large new supply of government debt to pay for looser fiscal policies. So far, $62.3 billion in government spending has already been approved by Congress to help rebuild the Gulf Coast economy; there is talk of this number going as high as $200 billion.

On Monday, expectations that the Fed will hike Tuesday to stifle

nascent inflation pressures led government bonds higher. The price of the benchmark 10-year Treasury note was recently up 6/32 while its yield was down to 4.25%. The gains were more pronounced in bonds with longer maturities, such as the 30-year bond, which was up 8/32 while its yield fell to 4.55%.

Monday's action reversed the trend since Katrina hit, whereby bond prices at the longer end of the maturity spectrum have taken a beating, with the effect of steepening the yield curve.

Richard Berner, economist at Morgan Stanley, says that investors looking forward to a Fed pause, or an end to the rate hikes, should be careful of what they wish for. A loosening in monetary policy would further steepen the yield curve, raising long-term interest rates and weakening the dollar, he wrote in a research note.

"A prolonged pause that allowed inflation to rise would be the worst outcome for both fixed-income and equity markets," Berner says. By contrast, "the Fed's commitment to contain inflation should flatten the yield curve and be good news for investors in risky assets."

A rate hike, accompanied by the Fed's usual commitment to fighting inflation, could therefore turn out to be bullish for both stocks and bonds Tuesday. However, the surprise is likely to be limited. Fed funds futures currently indicate the market is pricing in 96% odds of a rate hike Tuesday, according to Miller Tabak.

These considerations, however, seemed far from investors' minds Monday, as crude oil prices rose sharply on concerns that Tropical Storm Rita may also hit the already-ravaged Gulf Coast, as well as its energy production and refining facilities.

Chevron

(CVX) - Get Report

, for one, is already evacuating its offshore operations in the area. This, and uncertainty ahead of

the Fed's decision on Tuesday, sent major stock proxies sharply lower.

The

Dow Jones Industrial Average

was recently down 74.28 points, or 0.70%, to 10,567.66.

Exxon Mobil

(XOM) - Get Report

,

Altria

(MO) - Get Report

,

Hewlett-Packard

(HPQ) - Get Report

and

Microsoft

(MSFT) - Get Report

were the only Dow components in positive territory as of 1 p.m. EDT.

The

Nasdaq Composite

was down 13.36 points, or 0.62%, to 2146.99. In the broader market, the

S&P 500

was 6.16 points, or 0.50%, lower at 1231.75.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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