War Gives Markets Marching Orders
Stocks dropped at the open of the market Monday, then recouped their losses to see some of the biggest gains of the year. Meanwhile, bonds slumped.
“This is not sustainable,” said certified financial analyst Kurt Arvidson on Monday. “It just tells you how violent the markets are when you have a massive day on bonds. The violence of the moves says something in and of itself.”
Just four days earlier stock prices were down, bond yields were up and mortgage rates were popping back up slightly, he recalled.
Just because interest rates were up Monday and some investors were selling bonds and buying stocks, it doesn’t necessarily mean the behavior will last for weeks, said Arvidson, a partner with Grand Rapids-based Norris Perne & French LLP.
“Only ‘The Shadow’ knows — and he isn’t talking.”
He said the market would probably react very positively to a quick and decisive war, but if war drags on and casualties mount, interest rates would most likely start to move down again out of fear, and the stock market would be fearful as well.
Basically, Bush’s ultimatum signaled the beginning of the end of the uncertainty, said Jay Raniga, executive vice president of Heartwell Mortgage.
Supposedly, Raniga said, pent-up demand on both the corporate and consumer sides will be unleashed as soon as this geopolitical issue is resolved, and with the underlying fundamentals already in place, the economy is expected to begin growing again.
He said people have been blaming the Middle East crisis for the economic slowdown and once the war is over, they’ll find out whether they were right.
“The markets are usually six months ahead of the game,” Raniga said. “Interest rates came down in anticipation of this war six months ago, and now the markets are basically trying to predict what the world is going to look like in the next six months.
“The biggest outside issue is going to be whether there’s going to be a large increase of terrorist acts again within the United States because then it’s going to hurt demand again; people are going to stop flying, they’ll stop going to the malls. They’re going to be apprehensive and just sit on their hands.”
Overall, the trend in interest rates is going to be up, if people accept the common belief that the war will be a short and successful operation, said Michael Manica, president of United Bank of Michigan.
If corporations and consumers start spending money again and the economy recharges, interest rates will start rising again. If the economy does not pick up and there’s no demand, interest rates won’t budge, he said.
As most economists anticipated, the Federal Reserve decided Tuesday to keep its target for the federal funds rate, the overnight bank lending rate, unchanged at 1.25 percent.
Movements in the federal funds rate, a key short-term interest rate, normally give a good indication of the general shape and movement of the yield curve.
“Interest rates have moved abnormally low from a mortgage standpoint as well as a longer-term bond standpoint; it hasn’t been justified recently and now I think you’re getting back to where it should be on longer term interest rates,” Arvidson said.
Mortgage rates are typically tied to treasury rates. At the close of business last Monday the yield on the 10-year treasury bond had moved up only about 14 basis points to 3.84 from 3.70 three days earlier, noted said Mitchell Stapley, chief fixed income officer at Fifth Third Investment Advisors.
“Are we going to see interest rates back at 8 percent? No,” Stapley stressed. Interest rates will probably rise as soon as it becomes apparent that the war is going fairly well, with the 10-year yield going from about 3.7 percent up to most likely around 4.25 percent, he said.
“This is one of the few predictions I can make with any degree of certainty: This is not going to be a repeat of 1994 where the Fed came in and raised interest rates by 350 basis points over the course of the year. The economy is not generating jobs and is not growing. This is an economy that is still looking for an engine for growth.
“You’ll have interest rates back up on anticipation that the economy will grow, but that’s a lot different than what will happen when the Fed starts raising rates.”
Richard DeKaser, chief economist for National City, said the threat of war has been the single greatest business uncertainty of the past year. As that uncertainty fades away, the incentive to hire workers, build inventories and purchase capital goods all increase, he said.
The U.S. economy has many attractive and favorable economic fundamentals and the lowest financing environment most adults have seen in their lifetime, he said. Fiscal policy is such that government spending, both federal and state, is vastly exceeding its revenue.
“Those two factors alone are a good groove for a swiftly expanding economy.”
And an improving economy creates increased demand for credit, so as the corporate sector jumps back in with everyone else trying to borrow, it will drive up the real rate of interest, he explained.
“If the economy improves, the implications for the stock market are favorable because we will see superior earnings and, just as important, superior earnings expectations; that is, barring worst case scenario, analysts will increasingly view prospects for corporate profits more favorably.”
He believes the stock market rally will continue for a while because equities are attractively valued, and will continue to be even as interest rates rise. The equity market has been undervalued due to investor skepticism over all the corporate governance scandals, as well as the pall cast by months of geopolitical uncertainty.
Investor confidence went from unrealistically ebullient in 1998, 1999 and 2000, to unrealistically pessimistic last year, he said.
“I think we’re returning back to normal and will continue turning back to normal over time, but I’m not predicting we’re going back to the insanity of the late ’90s.”
Stapley said returns on the stock market this year are somewhat muted and that 7 percent to 10 percent yields are about the most investors can hope for.
Is investor confidence on its way back?
“I think you’re seeing a base beginning to build here,” Stapley said. “I think you’re seeing investor confidence being rebuilt.”
He said it looks like investors are beginning to have some confidence that the economy is not going to go into a double dip recession, that there’s not going to be an outbreak of deflation and that the war is going to be over quickly.
“We’ll be victorious, and once we get through that, consumer spending will pick up and that’ll be good for earnings. As investors cross each one of those thresholds, they’ll begin to put some money into the market.“Have we totally turned the corner? We’re not there yet. But I think we’ve seen some hopeful signs that people have begun to dabble back in.”