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We didn't slip back -- the market priced in.


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David Malpass

In recent weeks, stock prices have fallen while bond yields have risen — a bad combination. This has been a global phenomenon, hitting not only stocks in the U.S., but also European and Japanese equities, silver and gold, real estate trusts, Chinese equities, Japanese and Brazilian bonds, and currencies in Mexico and South Africa.

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And why is this phenomenon taking place? Markets have priced in several rate hikes by the U.S. Federal Reserve.

That said, economic growth in the U.S. is strong and strengthening. The initial interest-rate hikes by the Fed will act as an accelerant rather than a brake on the economy. With foreign growth also accelerating, and U.S. corporate profits continuing to grow fast, the equity markets should be able to overcome the prospect of a multi-year increase in interest rates.

Since March 24, interest-rate futures have added 60 basis points to the year-end fed funds rate expectation, bringing it back to nearly 2 percent. The rate is currently 1 percent, with today’s Fed meeting expected to result in only a long-overdue language-change in the central bank’s statement.

In many cases, markets have moved back to their late-2003 levels, having levitated early in 2004 on the (misguided) view that the Fed would leave interest rates at 1 percent into 2005. Gold, silver, the euro and the yen, the Nasdaq, the S&P 500, and other markets rose to a peak in the first quarter, then fell back to roughly their early December level.

The causal chain was from Fed statements to interest-rate expectations. Responding to the Fed’s expression of patience, expectations fell from December through March and the dollar generally weakened, while the dollar price of gold, other commodities, and many foreign currencies rose. Interest-rate expectations then climbed in late March and April, causing the dollar and other markets to return, in general, to their December levels.

A dominant factor in the dollar price of various assets is the value of the dollar, which fluctuates over a wide range. The dollar has strengthened sharply since late March, driving down the dollar price of the euro, yen, commodities, and foreign equities. Meanwhile, concerns about oil prices, Iraq, and the presidential election have only played a secondary role in the economy. These may act as drags on stocks and the economy, but the major player is still a constructive exit from the deflation cycle of 1997 to 2001.

Interest rates will inch up to 2 percent this year and then climb substantially in the U.S., Europe, Japan, and China over the next several years. But U.S. monetary policy will remain very accommodative even as the Fed pulls to 2 percent. This “free lunch” in liquidity will encourage leverage.

After that, the market will price in higher interest-rate expectations, again reevaluating the economic and policy climate.

– David Malpass is the chief global economist for Bear Stearns.



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