March 29, 1997

Why Is Rate Hike Such A Surprise?

Associated Press
 

One way or another, interest rates are going up, and stock prices are likely to fall. This shouldn’t come as a shock to anyone who follows Wall Street, but for some reason, a lot of people seem surprised.

No one was taken aback this past week when the Federal Reserve pushed short-term interest rates a quarter of a percentage point higher - actually, a lot of people were probably relieved, knowing an increase was inevitable.

But Thursday, a lot of jaws fell open and “sell” buttons were pushed, because it looked like interest rates would go up again.

What’s really interesting is that many economists have believed for some time that Fed Chairman Alan Greenspan, if he follows his past practice, can be expected to nudge rates higher several times over the course of the year.

In 1994, the Fed under Greenspan’s leadership doubled the federal funds rate, the interest banks charge one another on overnight loans, from 3 percent to 6 percent in seven increments.

Even before the Fed’s move this past week, Salomon Brothers Inc. economists predicted that after an initial 25 basis point increase (economists’ way of saying .25 percentage point), “An additional 25-50 basis points may be tacked on over the next few months.”

And as the market fell Thursday, Anthony O’Bryan, a market analyst at A.G. Edwards & Sons in St. Louis, said, “I think the consensus is it will get one or two more rate increases before the year is over.”

So why did the Dow Jones industrial average fall 140 points, and the Standard & Poor’s 500 index drop 16?

“Some folks were living in Never-Never Land,” said David Shulman, chief market strategist at Salomon Brothers Inc.

William M. Lefevre, a senior market analyst, said the market was overreacting.

A big sell signal Thursday came when the yield on the Treasury’s 30-year bond crossed the dreaded 7 percent threshold. But panicky stock traders might actually see - if they look closer - something positive in that apparent calamity:

Rising market interest rates have the same effect as a Fed increase - they filter through the rest of the economy and can have a chilling effect on business activity.

So if rising market rates do the trick, the Fed doesn’t need to restrict credit further. The bond market, in a self-fulfilling prophecy of sorts, will have brought about the outcome it feared. And stock traders, who fear rising interest rates will depress earnings and make bonds more attractive than equities, will have already sent prices down.

But it’s important to remember that however preoccupied investors seem with interest rates, other factors, including some that have little to do with the economy, also drive the markets, which were closed for Good Friday.

The Wilshire Associates Equity Index - which represents the combined market value of all NYSE, American and Nasdaq issues - ended the week at $7.38 trillion, off $91.24 billion from a week earlier. A year ago the index was $6.37 trillion.

© Copyright 1997 Associated Press. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.


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