Fed rate hikes anticipated
By Adam Shell
NEW YORK Will future interest rate hikes by the Federal Reserve put the brakes on the stock market's recent rally? Not necessarily.
Historically, stocks have performed poorly after the Fed starts upping borrowing costs. In fact, pundits say the Fed's last rate-tightening campaign, which began in the summer of 1999, killed the 1990s bull market. Six months after the first hike, the Standard & Poor's 500 was 9.4 percent lower, InvesTech Research says.
And now with the economy perking up, investors expect the Fed to start raising rates again, perhaps as early as June. But, unlike the past, that doesn't mean stock prices will suffer a quick, painful contraction if rates do rise, some experts say.
"Any short-term tweak of rates by the Fed will be more akin to taking a foot off the gas than applying the brakes," says Steve Galbraith, chief investment officer at Morgan Stanley Dean Witter. What's different this time?
Rates are at 40-year lows, buffering the impact of future hikes. None of the prior periods in which the Fed was raising rates started with rates so low. After major economic disruptions caused by the crash of technology stocks and the Sept. 11 terror attacks, the Fed slashed rates 11 times last year, knocking short-term yields down to 1.75 percent from 6.5 percent.
Rate cuts after Sept. 11 were more psychological than economic. Fearing a stock market meltdown and liquidity crunch after the terrorist attacks, the Fed cut rates four times afterward. Some say the final two cuts late last year were meant to restore confidence rather than spark economic growth.
"The first few take-backs of 9-11 interest rate insurance by the Fed might not carry the same weight as prior tightening periods," Galbraith says.
The Fed's language will be market-friendly. It won't be sold as a tightening campaign, says James Stack, president of InvesTech. "It's going to be sold to the public as important steps to ensure a stable, longer-term recovery."
Inflation is virtually nonexistent, making it less likely that aggressive hikes will be required.
But a series of rate cuts over a longer period will eventually become a drag on stocks. The reason: As yields rise, returns on cash and bonds become more competitive with stocks, Stack says. And interest-sensitive parts of the economy, such as homebuilders, home-improvement retailers and banks, will be hurt, creating a drag on the economy.
One red flag to look out for: rising long-term bond yields. If yields on 10-year Treasuries top 6 percent (it's now at 5.4 percent, up from 4.2 percent in November), it's usually a negative for stocks. "It signals that the trend for rates is up, not down," Stack says.
Some cautious investors say it's time to consider taking profits now that the Fed is leaning toward hiking rates, regardless of how good the economic recovery gets.
"We'd be looking to sell into rallies," says Ray Dalio, equity strategist at Bridgewater Associates.