Stocks in U.S. Endangered by Forecasts of 6% Fed Target Rate
July 3 (Bloomberg) -- U.S. stocks are threatened by predictions the Federal Reserve will raise its benchmark overnight lending rate as high as 6 percent.
Barclays Capital Inc. forecast the Fed's target rate will reach 6 percent by the end of the year. JPMorgan Chase & Co. and Credit Suisse Group made similar calls for next year. Last week, policy makers lifted the rate to 5.25 percent, the 17th straight increase.
There have been eight time periods since the 1960s when the so-called federal funds rate was 6 percent or higher. The latest began in March 2000, the start of a three-year bear market for stocks. Prices dropped in three more periods and had losses during two others.
``Six percent would make us decide to pull back our equity allocation,'' now about 50 percent, said Peter Wall, who helps oversee about $80 billion as chief investment strategist at JPMorgan Private Client Services in New York. The rate ``would increase the risk of recession in 2007.''
U.S. stocks last week broke a three-week losing streak, the longest in eight months, and had the biggest one-day rally since 2003. Prices rose as Fed policy makers said in a statement that the economy is slowing, evidence they may refrain from raising rates at their next meeting.
The Standard & Poor's 500 Index gained 2.1 percent, the largest weekly increase since January, to 1270.20. The Dow Jones Industrial Average advanced 1.5 percent to 11,150.22. The Nasdaq Composite Index rose 2.4 percent to 2172.09.
Shifting Sentiment
Some forecasters took the Fed's statement to mean rates won't rise any further. Policy makers are done lifting rates, said Paul McCulley, managing director at Pacific Investment Management Co. in Newport Beach, California. Pimco runs the world's biggest bond fund and manages more than $590 billion.
Concern that higher rates would choke off economic growth led to a 1.9 percent loss for the S&P 500 in the second quarter. While the Dow industrials rose 0.3 percent, the Nasdaq Composite dropped 7.2 percent after rising for four straight quarters.
Pessimism on U.S. stocks climbed last week to the highest since October 2002, when share prices dropped to five-year lows, according to a weekly survey of investment advisers by Investors Intelligence. The percentage of bearish newsletter writers rose to 36.3 percent from 35.6 percent in the week ended June 23, the New Rochelle, New York-based newsletter said.
The Fed's statement led to a change in sentiment. Traders reduced the odds that the Fed will go to 5.5 percent next month to about 60 percent from 83 percent before last week's increase, according to interest-rate futures.
`Disastrous' Rate
The central bank has lifted the target rate by a quarter percentage point at each policy meeting since June 2004. At that pace, the central bank would have to raise rates at three of the year's four remaining meetings to meet Barclays' forecast.
Dean Maki, Barclays' chief U.S. economist, made his estimate on June 22 during nine consecutive days of higher yields on the benchmark 10-year Treasury note. The streak was the longest since 1974.
Maki, based in New York, said June 30 that he was sticking with the rate prediction. Barclays is one of the 22 government- securities dealers trading directly with the Fed's New York branch.
Bruce Kasman, JPMorgan's head of economic research, and Neal Soss, chief economist at Credit Suisse, also reaffirmed their forecasts. Both are in New York. JPMorgan sees the Fed raising the funds rate to 6 percent by March.
Previous Losses
A 6 percent rate ``would be disastrous for stocks,'' said Barry James, who helps manage $1.7 billion as the chief equity strategist at James Investment Research in Alpha, Ohio. Rising to that level would ``definitely have a very crippling effect on the economy and stocks.''
History backs that sentiment. Three days after the rate reached 6 percent in March 2000, the S&P 500 set its all-time high. The index slipped 5.7 percent through January 2001 as the ``Internet bubble'' of the 1990s started bursting.
Prices kept falling even after the rate slipped below the threshold. By October 2002, the index had plummeted 49 percent from its all-time high.
The biggest decline with the rate at 6 percent or higher occurred between January 1973 and March 1975, when the S&P 500 declined 29 percent. The index also plunged 20 percent on Oct. 19, 1987, 11 months after the Fed went to 6 percent.
Rates were above 6 percent between August 1977 and August 1986, and went as high as 20 percent, as the Fed sought to tame inflation. Even though the S&P 500 more than doubled during the period, it started out by losing 11 percent through March 1978.
Financial Shares Fall
Bear markets are correlated with the Fed going to 6 percent, said Tim Hayes, chief investment strategist at Ned Davis Research Inc. in Venice, Florida, who uses historical data to help clients invest. What's more, he said, the current level of rates is hurting stocks by slowing the economy.
``We've already moved enough for it to be a problem,'' Hayes said. ``Six percent would be the nail in the coffin for the market.''
Earnings are climbing even as rates increase, which may sustain stocks. For the second quarter, S&P 500 companies are set to report a 12th straight quarter with at least 10 percent earnings growth, according to Thomson Financial. There has been only one other streak that long since 1950.
``Corporate profits remain very, very strong,'' said John Calamos Sr., who helps manage about $48 billion as chief executive officer at Calamos Asset Management Inc. in Naperville, Illinois. ``To us, it's very unlikely we're going into a recession with corporate profits up.''
Losing the Impetus
Further rate increases are dependent on inflation readings for the next several months, according to the Fed. A gauge that the central bank favors climbed 2.1 percent in May from a year ago, according to a report on consumer spending last week.
Still, the Fed expects the U.S. economy to moderate. The Commerce Department said last week that the economy expanded at a 5.6 percent annual pace during the first quarter.
Slower growth may pose a challenge for stocks along with higher rates. The recent expansion ``is as good as it gets,'' said James. ``That takes away the impetus to own stocks.''
To contact the reporter on this story:
Nick Baker in New York at
nbaker7@bloomberg.net
http://www.bloomberg.com/apps/news?pid=20601109&sid=aN66GVcj25Dw&refer=exclusive_to_bloomberg
