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May 18, 2004 |
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1987: Stock market crash. 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 |