Before You Decide, Consider the Trends

By the time you read this, we’ll all know whether Friday’s Wall Street mayhem was a one-day wonder or the start of something much bigger.

But whatever happens today, the trends that set up Friday’s interest-rate surge and 171.24-point dive in the Dow Jones industrial average, to 5,470.45, may be more important to focus on than the events themselves.

In other words, before you make investment decisions based on one or more days of sinking stock prices and rising interest rates, think about the cause, not just the effect.

Here are some of the trends that are likely to keep driving markets:

* The U.S. economy isn’t rolling over. The markets were roiled Friday by news that the economy created 705,000 new jobs in February, a huge number that triggered fears of an economic boom and thus rising interest rates and inflation. Yet it was tough to find an economist who didn’t try to paint the employment report as a fluke.

“Most of the job gains posted in February were in highly seasonal industries,� argued Bruce Steinberg, economist at Merrill Lynch & Co.

In fact, in three of the last six years, February has posted the year’s largest monthly payroll gain, he said--the suggestion being that you can’t simply extrapolate February’s job numbers to mean the economy will boom.

Indeed, monthly economic data often are revised 30 days later, something that seemed lost on panicked bond traders Friday.

Nonetheless, most economists now grudgingly acknowledge that recent widespread concerns that the U.S. economy was teetering on recession were misguided. Even allowing for a seasonal boost in the February employment data, “the surge in jobs was undoubtedly strong,� said Asha Bangalore, economist at Northern Trust Co. in Chicago.

The implication: If, at the very least, the economy isn’t getting weaker, the Federal Reserve Board may have no reason to cut short-term interest rates any further. Until Friday, more rate cuts were considered virtually certain.

* Without another Fed cut, market interest rates may not be able to decline much from here. It’s easy to say that bond traders overreacted on Friday to the threat of faster economic growth and thus higher inflation, pushing longer-term bond yields up more than a third of a percentage point.

But then, they also had overreacted in pushing yields down last year and into January, betting heavily on a withering economy and additional Fed rate cuts.

Where should longer-term bond yields be, if the Fed decides to keep short-term rates where they are?

Based on the current 5.25% federal funds rate--the Fed’s benchmark short-term interest rate that is the overnight loan rate among banks--bond yields probably shouldn’t be any lower, at least not on intermediate-term securities like two-year and five-year Treasury notes.

The two-year T-note yield soared from 5.39% on Thursday to 5.74% on Friday. That means it’s about a half percentage point above the fed funds rate. Some bond market pros say that’s not enough of a spread, especially if you think that the Fed’s next move--maybe not soon, but by year’s end--will be to begin raising short rates again.

*

Normally, after all, you’d expect interest rates to be upward sloping, meaning you’d expect to be paid more for taking the risk of owning longer-term securities.

The five-year T-note yield, meanwhile, surged from 5.72% to 6.07% Friday. Although the new yield is more than three-quarters of a point over the fed funds rate, that, too, is narrow by historical standards.

Consider: For most of 1994 and 1995--a period that encompasses both stable and rising Fed rates--the spread between the fed funds rate and the five-year T-note yield was 2 full percentage points.

Of course, higher interest rates could cause a fresh slowdown in the economy. And there’s always a chance that Congress and President Clinton could resurrect balanced-budget talks, giving the bond market something new to hope for.

But for now, if the Fed has stopped cutting rates, the bond market rally isn’t going to resume.

* Bonds’ horrendous volatility is making a bad situation worse. In 1994, the bond market suffered its worst bear market of this century as long-term yields rocketed with the strengthening economy, slashing bond values. And just as abruptly, yields plunged last year as the economy slowed.

Now, in the space of just over one month--and without the slightest hint that the Fed is close to raising rates again--the two-year T-note yield has surged from 4.89% to the current 5.74%. Interest rate moves like this used to take many months, or even years.

It’s easy to blame the hedge funds and other powerful short-term traders for the bond market’s crazed swings. Whoever’s responsible, bonds’ turmoil will only discourage more investors from even bothering with bonds. Why take the risk to your principal for what are paltry yields anyway?

Even professional buy-and-hold investors may reassess why and how they invest in bonds.

Matthew Hand, bond trader at UBS Securities in New York, notes that as market interest rates began to creep up in February, investors’ natural reaction was to sell long-term bonds and buy shorter-term securities like the two-year T-note, figuring they’d be “safer� there. In retrospect, they should have just gone to very-short-term “cash� investments, Hand says.

For individuals, who have on balance invested very little in bond mutual funds since the 1994 bond market debacle, this latest bout of volatility will only reinforce the sense that bonds are too much trouble, some experts say.

“We’re all asking, ‘Who’s going to be buying bonds now?’ � said a worried Jack Kallis, bond fund manager at the Met Life/State Street funds in Boston.

The answer may be that the market becomes even more controlled by speculators.

* The stock market could ultimately benefit from the economy’s rebound and bonds’ upheaval. Everyone says stocks are overdue for a significant pullback after their stunning gains of the past 14 months. And that’s fair enough.

The Dow’s 171.24-point loss on Friday as interest rates jumped amounted to 3% decline, and most broader market indexes also lost 2% to 3% for the day. That’s a substantial loss, by any measure, and investors who are itching to take profits could do more damage to the market this week.

Wall Street frets that the market hasn’t suffered a 10% pullback since this bull market began in October, 1990, but that’s misleading. The Dow lost almost 10% in the spring of 1994 as the Fed boosted short-term interest rates.

And in any given year, many stocks individually are hit by 10% pullbacks or much deeper declines.

The only question really worth pondering is whether Friday’s employment report was news that fundamentally changed the way people think about the stock market. In other words, is there no longer any reason to be longer-term bullish?

*

Start with the economy. If it’s going to improve, most investors know that that should mean another boost to the corporate profits that underpin stocks.

“A good economy with low inflation does not seem to me to be a reason to sell stocks,� said Howard Gleicher, money manager at Palley-Needelman Asset Management in Newport Beach.

Second, this bull market has to a large degree depended on cash inflows from individual investors, via mutual funds. Will that money flow stop?

Investors would need somewhere else to go with that cash. Bonds? As noted above, small investors have invested little in bond funds since 1994, and the latest bond market turmoil isn’t likely to make bonds more attractive than stocks for most people.

Money market funds or bank CDs? While long-term interest rates have leaped over the past month, very short-term rates, such as on three-month T-bills, have remained stable, and they won’t budge from current levels until it begins to look certain that the Fed will begin to tighten credit again, risking recession.

In sum, the fundamentals still appear to favor the bull market, aged though it is. That doesn’t mean there can’t be more damage done to stocks in the near term by nervous traders at the margin. But you would have to be very confident in predicting either recession or much higher interest rates soon to ignore the buying opportunity that a broad-market pullback would provide.