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May 18, 2004
A repeat of 1987, 1994, 1998, or 2000?

1987: Stock market crash.
1994: Bond market debacle.  
1998: Capital treats US as ‘safe haven’ following Russian/Asian crisis.
2000:  Stock markets top out early in the year.

Bond market comparisons between 2004 and 1994 abound.  Moreover, given the recent fallout in emerging markets compared to the relatively sturdy US markets (and US $), financial market comparisons between 2004 and 1998 could easily creep back into the mainstream. Nevertheless, for my money the comparison that deserves the most attention – and which is receiving none these days – is the year 2000. 

2000 Flashback

The ‘foreseeable future’ becomes as accurate a forecast as ‘next week’

In 2000 the Fed hiked interest rates (May 16) and spent most of the year warning on inflation. However, by December the Fed changed its statement:

“…the Committee believes that the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future.” December 2000

The above statement may not appear to be that important. Keep in mind, however, that the Fed spent the entire year warning of inflation. 

“…the risks continue to be weighted mainly toward conditions that may generate heightened inflation pressures in the foreseeable future.” November 2000

This flip flop – from envisioning inflation in November 2000 to economic weakness in December 2000 - serves as a warning to investors today. To be sure, Greenspan and company went from warning on inflation in November 2000 to cutting interest rates at surprise meeting in January 2001.  In less than two months the Fed’s policy outlook dramatically changed. 

Why 2004 will be like 2000

Other things being equal, the Fed will raise interest rates next month for the first time since May 2000.  Accordingly, with respect to interest rates the astute conclusion from historians is that 2004 is threatening to emulate 1994, not 2000.

But alas, it is the late year trend in interest rates that could see 2004 end up being a repeat of 2000.  Moreover, it is the potential for a stock market slump that makes a repeat of 2000 more likely than 1994 (in 1994 the S&P 500 closed flat on the year). 


As value manager Bill Nygren recently noted, “the bond market already incorporates somewhere between a 75 basis-point and 100 basis-point increase by the Federal Reserve”. In other words, rate hikes from the US Fed are already priced in, and it will take even stronger economic/inflation growth to push market rates even higher.

The question that deserves to be asked is ‘will the Fed need to hike interest rates by more than 100bp to cool down a US economy that was likely to cool down in the latter half of the year anyways?’  I don’t think so, which is why dramatic policy shifts from the Fed could be in the cards this year. Or why just as the Fed begins to worry about inflation the problem of economy weakness comes back into play in late 2004/early 2005.

Where Will Rates Go?

This opinion is not to suggest that current jump in interest rates is over.  On the contrary, if energy prices don’t stop rising and/or Chinese actions to slow global growth do not yield immediately results, interest rates could continue to rise for much of the year.  

Nevertheless, remember that the Fed was largely responsible for helping engineer the US economy/stock market recovery. Now that the housing refi bonanza is over, that the flood of savings into stocks is subsiding, and that record debt loads will not be paid off in full if (as) interest rates rise, there is little reason to believe that the US economy is not poised to cool down naturally. In other words, remember that higher rates – while not guaranteed to cause financial disaster – are already (before the Fed hikes once) nullify many drivers of growth.



The 1998 Wild Card Scenario

1998 proved that when all else fails capital will funnel into the US.  To highlight this experience one chart will suffice: notice how rising interest rates did nothing to stop the stock market bull.



Conclusions

Contrary to popular opinion, interest rates could follow the 2000 trend instead of the 1994 trend. As for stocks, they have already followed the topping trend seen in early 2000, and are likely to suffer due to lack of new liquidity for the remainder of the year. Remember that 2000 was a down year for stocks primarily because the liquidity situation turned negative. A similar phenomenon is readily developing today as investors stop buying into the ‘buy stocks because bonds are unattractive’ mantras.

Incidentally, there remains the possibility of another 1987. As rare as 1987 was, it is possible that a repeat occurs in 2004 if the interest rate situation gets out of control. Quite frankly, it is not difficult to envision rising interest rates will coincide with a policy misstep (Baker – 1987) given that the global financial markets are already extremely jittery when it comes to US interest rates. 




Analysts On Interest Rates

As for the analysts, they - nearly universally – continue to treat the ‘foreseeable future’ as ‘next week’. To be sure, few warn of the ominous fact that the Fed is preparing to raise interest rates just as the US economy is expected to cool, and fewer still treat the 1998-2000 period as little more than an anomaly.  Instead, many see rising interest rates as terrific news.

“The market always gets scared in the middle of a policy shift.  It tends to freeze for a while. But as the process gets under way, that's usually the green light for the equity market."   James Glassman, senior economist for J.P. Morgan Chase (May 14)

“A few interest-rate increases could actually be good for equities, because they will dampen inflationary pressures.” James Stewart, SmartMoney

“It might have taken a few years, but the fact that interest rates have finally started to rise is a great sign that our economy is back on the right track.” Greenberg, Your Money


A Fed policy shift is a green light for the equity market? A few interest-rate hikes could be good for stocks?  Rising interest rates are a great sign that the US economy is back on the right track?  In other words, rising interest rates are fabulous news?...

The reality is that rising US interest rates have already sapped liquidity from the financial markets, hammered the refi market, threatened to pop the hot US housing market, and have been said top be largely responsible for steep equity sell offs around the globe. 


BWillett@fallstreet.com