Signs of an economic slowdown continued to mount last week, but some fear the resulting rally in bank stocks may have run its course.
"The jury is still out," said Gary Schlossberg, senior economist at Wells Fargo Bank, San Francisco. "We don't yet know how much the economy will be slowing down. Beyond that, we don't know if it will be a sustained slowdown leading to real sluggishness later this year, or just a pause after a strong fourth quarter."
The financial markets recently seem to have assumed that the slowing will indeed be sustained. That implies interest rates will not have to be increased by the Federal Reserve beyond their current levels.
"The markets have been putting a very positive spin on this," Mr. Schlossberg said. In fact, a considerable amount of economic guesswork is involved, he noted.
But last Thursday, as if investors suddenly entertained doubts about the strength and direction of the economy, the impressive month-long rallies in both bonds and bank stocks, gave way to selling pressure.
The weakness persisted Friday, with many investors apparently unnerved by the slide in value of the dollar on foreign exchange markets versus the Japanese and German currencies despite intervention by the Fed and other central banks.
The dollar's woes and the subsequent distress in other markets were laid to growing concerns about the impact of Mexico's economic and currency crisis on the U.S. economy.
"The situation suggests that the Fed may now have to turn its attention from the domestic economy, which it has been focusing on, to these problems related to emerging markets like Mexico," said Sung Won Sohn, chief economist at Norwest Corp., Minneapolis.
If last week's reports of slower sales of existing homes and of autos signal only a temporary break in business momentum after the robust expansion of last fall, the outlook would be more uncertain for banks.
A brief time-out from strong economic growth, instead of a clear shift toward recession, could leave it unclear whether the central bank might need to tighten credit again in its campaign to avert a rise in inflation.
Mr. Schlossberg and others also noted that inflation could rise even as the economy moderates, leaving open the possibility of Fed action and keeping a lid on bank stocks. Most Wall Street analysts feel banks cannot begin a solid rally until rates have clearly peaked.
Eugene J. Sherman, research director at M.A. Schapiro & Co., New York, said he feels that coming economic developments will show a moderation in the rate of growth to a lower but still rapid pace.
"Under those circumstances, inflationary pressures will intensify," he cautioned.
Mr. Sherman said many investors may have misread recent statements by Fed Chairman Alan Greenspan and Vice Chairman Alan Blinder as indicating the Fed is done raising rates.
"What does seem to be clear from the various Fed officials' statements is that they are now prepared to pause for a while, an undefined period, and monitor economic developments," he said.
"There is no (Fed) commitment at that stage to either tighten or ease, only to pursue lower inflation over the longer run," Mr. Sherman said.
Soon, he predicted, Fed officials would begin making this stance clearer, with dampening effects on the bond market, which is guiding bank stock investors at this phase of the business cycle.
"Some backtracking is in prospect," Mr. Sherman said. "The market has misread the signs and gone down a false trail. It must go back."
Bond and bank stock investors may want to eye the sidelines, he said, suggesting "this would be a good time to become philosophical."