The latest bulge in the huge U.S. trade deficit is a strong sign that the Federal Reserve will raise interest rates again soon, which is not a good sign for bank stocks.
Bank shares swooned and bond yields soared last week after the government reported that the nation's negative gap in international trade unexpectedly ballooned to $26 billion in October. That topped the July record by more than $1 billion and was $1.5 billion more than economists had predicted.
"A rate hike is coming; the only question is when," said Joel L. Naroff, chief economist for Commerce Bancorp of Cherry Hill, N.J.
The central bank's open-market committee meets tomorrow in Washington. With year-2000 uncertainties looming, a rate hike is not expected, but a switch to a tightening bias on monetary policy from neutral could materialize.
That could set the stage for a rate hike as early as the committee meeting on Feb. 1-2, assuming the year-2000 changeover goes smoothly for most computerized information systems. Beyond that session, the policymakers next gather March 21.
The huge trade gap will trim fourth-quarter growth of the economy, but few observers think the impact will be large enough to head off Fed action. The Fed has been warning since August that the economy is exceeding the speed limit - that is, growing faster than its maximum sustainable noninflationary trend rate of 3.5% annually.
Ian Shepherdson of High Frequency Economics in Valhalla, N.Y, said Friday that he was not yet ready to cut his forecast of a 5.5% annual growth rate in the fourth quarter. He said it would be "wildly premature" to conclude that the chances of further Fed action have been reduced.
Mr. Naroff said: "A widening trade deficit may slow growth, but that is little solace for the Federal Open Market Committee. The trade situation is a direct consequence of the incredible strength in the U.S. economy, and that is what the monetary authorities will be focused on."
The burgeoning U.S. money supply is yet another reason that rates are headed higher - maybe significantly higher than now anticipated, said Kenneth T. Mayland, chief economist at KeyCorp in Cleveland. He said another 1.25 percentage points may be added to the federal funds rate unless business conditions slow significantly.
Until last spring, the economy was being treated to "an extra helping of liquidity," Mr. Mayland said, with the money supply hitting a peak growth rate as high as 15% on a year-over-year basis.
"All that money floating around helps explain why the economy's performance exceeded expectations, why loan growth has been so strong, and why stock prices have been on a multiyear tear," he said. The Fed, he said, can be expected to raise short-term rates as a way of slowing money growth to a pace that carries less potential for inflation.
Braking money growth has begun and could last up to two and a half years, judging from the last two money supply cycles.
These periods "are not to be taken lightly," Mr. Mayland warned. The last two cycles included the dramatic stock market crash of 1987 and the sluggish economic growth period in 1995.
The KeyCorp economist said the markets have a history of not anticipating how much Fed monetary tightening will occur. The Eurodollar futures market last April discounted only one rate hike for 1999. So far, there have been three.
He pointed out that the credit-tightening cycle of 1994-95 involved a hike of 3 percentage points in the federal funds rate, whereas the 1987-89 tightening constituted a 4-point rise. This time around, he said, a total of 2 points' worth of tightening from the Fed would not be unlikely.
