WASHINGTON - Perhaps one reason the financial markets seem a little befuddled lately is that investors are more uncertain than usual about what lies ahead.
One problem is figuring out what to make of the drop in interest rates and the big run-up in stocks and bonds since the beginning of the year. The weak U.S. dollar and lingering questions about what the Federal Reserve will do add to the uncertainty.
Since November, the average fixed-rate mortgage has fallen from 9.25% to 8.40%, and the 30-year Treasury bond's yield has dropped from 8.15% to around 7.45%.
This drop in interest rates has pushed up stock prices. The Wilshire stock index, the broadest measure of the market's performance, is up more than 8.5% since the beginning of the year.
Analysts at Chemical Securities Inc. say the drop in rates has largely undone the effects of the Fed's last two credit-tightening moves on Nov. 15 and Feb. 1. They also calculate that the upturn in stocks has added more than $275 billion to household portfolio wealth.
"The financial markets are giving the economy a gift, and the Fed is going to have to do a lot more tightening," says Jim Glassman, an economist at Chemical Securities. He expects Fed officials to raise short-term rates several more times from 6% to 7.5% by the end of the year as more inflation news hits the screens of bond market traders.
At Salomon Brothers Inc., analysts believe the Fed will raise rates another half a percentage point to 6.5%, and possibly 6.75%, by the end of the year. Economist Susan Hering says the recent drop in rates will spur a revival in home construction, helping to crank up the economy in the second half of the year. She also expects consumer spending to revive after a slack period that will end this spring.
Others are saying the Fed has largely succeeded in achieving a "soft landing" for the economy that will produce mild growth and keep inflation under control. The forecast at NationsBank Corp. is for no change in Fed rate policy for the rest of the year, says economist Peter Kretzner.
Mr. Kretzner argues that the decline in interest rates so far this year will act as a buffer in a gently declining economy, not as a major stimulus for the Fed to raise rates again. "The interest rate reductions we're seeing are the market's response to a weakening of the economy and the idea that the Fed is done," he says.
Robert Robbins, market strategist for the Robinson-Humphrey Co. in Atlanta, cautions against excessive worrying about the Fed. Many investors are still confident that a soft landing can be achieved, even with some additional rate restraint by the central bank, he says.
"Stocks have discounted a soft-landing scenario for the last four or five months," says Mr. Robbins. He adds that he would not be surprised to see stocks stuck in a range of 4,000 to 4,300 on the Dow for the rest of the year.
The Bond Buyer is a sister publication of the American Banker.