A Central Bank Triple Play
Produces Worries
Some Money Managers Begin to Fret
Over Potential Fallout on Markets
If U.S., Europe, Asia Raise Rates
By E.S. BROWNING
March 13, 2006; Page C1
Investors love it when the economies of the U.S., Europe and Asia all grow strongly at the same time.
They hate it when the central banks of those three regions decide to cool things off by raising interest rates at the same time.
That is what is happening now, and some money managers are responding by hunkering down and preparing for trouble.
"That trifecta of major central banks raising rates all at once is going to trouble the markets for some time," worries Kevin McClintock, chief investment officer for stocks at money-management firm Babson Capital Management in Cambridge, Mass. A stock pullback of as much as 10% "is increasing in probability," he says. He is cutting his stock exposure, increasing his cash reserve and switching money toward bigger, safer stocks.
Many investors shrug off that kind of warning, and it is hard to blame them. They have heard it before. Since 2004, the market's Chicken Littles have said that the Federal Reserve's steady increase in short-term interest rates would push longer-term bond yields through 5%. It hasn't happened.
The reason: Even as the U.S. Fed kept trying to make it more expensive to borrow money, foreign central banks maintained their easy-money stances. Lower interest rates and other measures pumped more cash into their economies than could be absorbed. Money from abroad poured into the U.S., seeking higher U.S. interest rates.
Record U.S. trade deficits pumped dollars abroad, which foreigners obligingly recycled into U.S. Treasury bonds and notes. The heavy demand for U.S. bonds kept U.S. bond yields from rising much, which in turn kept U.S. mortgage rates low. Consumers borrowed and spent, and money was cheap despite the Fed rate increases. Warnings of coming trouble increasingly were ignored.
Despite a bout of nerves last week as bond yields rose again, that kind of hopeful thinking has survived.
The Dow Jones Industrial Average rose 104.06 points on Friday, helping it recover from earlier declines and finish the week ahead by 54.75 points, at 11076.34.
Many investors remain convinced that a strong economy will produce strong corporate profits, permitting stocks to march higher even as rates rise. Since inflation remains benign, the widespread view is that the Fed soon will stop raising U.S. short-term rates, taking the pressure off the U.S. economy.
That reassuring scenario may yet play out this year, but a growing number of professional investors are afraid it won't.
Last week, for the first time in five years, the Bank of Japan indicated that Japan's economy finally is strong enough for it to begin pulling cash out of the financial system. Later this year it is expected to start raising its benchmark short-term interest rate from near zero, where it is right now. Europe's central bank has indicated that it also will raise rates this year.
And with U.S. economic indicators such as Friday's report of payroll growth showing surprising resilience, some money managers are thinking that the U.S. Fed will be raising rates for longer than it had hoped.
"They are going to keep raising rates. I don't think there is actually an end in sight," says Edgar Peters, chief investment strategist at PanAgora Asset Management, which manages $18 billion in Boston. "There will be at least three more rate increases, maybe four or five, and the market in general doesn't seem to be prepared for that."
One sign that the rate increases could take a bigger toll this time: Treasury-bond yields are hitting their highest levels in nearly two years.
The yield of the benchmark 10-year Treasury note finished the week at 4.765%, a level it hadn't seen since June 2004. Expectations are spreading that it soon could break 5%, for the first time since 2002.
Higher bond yields hurt stocks in two ways.
First, they turn bonds and even cash into an increasingly enticing alternative to stocks. "It used to be that if a stock yielded 5% it was pretty attractive," Mr. Peters says. But with money funds starting to move in that direction, a safe, insured bank account looks increasingly desirable to conservative investors.
Higher yields also slow the economy's expansion.
That is the whole reason the Fed raises rates in the first place -- to prevent inflation by slowing growth rates.
Many stock investors are watching the bond market for signs of where stocks are headed. "I think Mr. Bond is a great forecaster," says Jon Brorson, who oversees $2.3 billion in assets as head of "growth"-stock investing at money-management firm Neuberger Berman. Higher rates and other moves to pull money out of the financial system "are going to put further downward pressure on the financial markets -- stocks and bonds," he says.
Until last week, Mr. Brorson favored smaller stocks, which tend to perform well in a strong economy. Last week, he began cutting his position in those stocks, shifting money toward larger, more stable stocks with healthy balance sheets and relatively low stock prices compared with their profits -- which he thinks will be better able to weather a storm in the market.
"The market feels a lot like it did in March of 2000, right near the top," says Mr. McClintock of Babson. He doesn't expect a pullback nearly as severe as that one, but he has the same sense of excess market optimism at a time when the economy is slowing and bond yields are rising.
Even the pessimists figure that bond prices will suffer more than stock prices. The prospect of higher interest rates makes existing bonds, with their lower yields, look relatively unattractive.
Fears are spreading again that the Fed will keep pushing rates up until some blowup occurs in the financial markets or the economy -- at a big investment fund, for example, or in the housing market.
"To the extent that the Fed, the Bank of Japan and the European Central Bank are all tightening at the same time, we believe the chances for a financial crisis have increased," wrote investment strategist Jason Trennert of brokerage and research firm International Strategy & Investment in a report to clients Friday. Mr. Trennert said that he is optimistic over the longer term that a resilient economy will push stocks higher. "In the short term, however, we would be a little more cautious," he wrote.
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