Economist Nick Perna: Fed Funds Rate Up 1% Mid-2015, 10-Year: 3% End Of '14, 4% End Of '15.

by: Harlan Levy

Summary

Further stock gains tough since interest rates will rise.

2014 GDP growth may be 2.7%, Fed funds rate up 1% by mid-2015, 10-year: 3% end of 2014; 4% end of 2015.

Europe faltering with no stimulus plans is bad for U.S. exports.

Economist Nicholas Perna is the economic adviser to Webster Financial Corp. and managing director of consulting firm Perna Associates. He has also been a visiting lecturer at Yale University.

Harlan Levy: Is the market overvalued and a correction overdue?

Nick Perna: I'm amazed that stock prices are as high as they are, and I'm amazed also at how low bond yields are.

Equity prices reflect several things: very low return on alternatives like bonds and a fairly high level of uncertainty in the world. As we look forward I think that it's quite possible for stocks to maintain much of what they have, but it's going to be difficult under the most likely scenario, because the betting is that interest rates will be rising. That makes it clearly difficult to get further gains in equities.

But I think it would take one of the numerous downside risks to throw stocks into a tizzy.

Q: Are there any that may surprise me?

A: If this were a weather forecast with lots of tropical depressions and potential hurricanes, here's a potential storm: It's not on everyone's radar screen, but I'm not sure what's going on in Argentina. They have defaulted on their sovereign debt. Maybe it's not like the previous defaults which Argentina had, because it's brought to you by a legal challenge by some hedge funds that are trying to make a ton of money off Argentinian debt. If this one isn't resolved it could precipitate a problem someplace else. We could have another international debt crisis on our hands. It's worth watching this "tropical depression."

Q: What are some other potential storms?

A: The next one would be Russia and Ukraine, brought to you by Vlad the Invader. That one has the potential to truly further weaken the European economy. Most people assume it will have a fairly benign ending, but, to quote Yogi Berra, "It ain't over 'til it's over."

Also, the latest data shows that Europe's economic recovery is faltering, as of the second quarter. One consequence of this is that it doesn't bode well for U.S. export growth. The Europeans are in a bind. They reinvented austerity, and they're not about to deal with the problem through fiscal stimulus. It's difficult for the European Central Bank to provide large amounts of monetary stimulus, including lower interest rates and quantitative easing.

One limitation is that interest rates are already low. The other limitation is that I doubt that Germany and other northern European countries would be tickled to see massive quantitative easing, because of deeply rooted fears of inflation, when in fact the real problem facing Europe is deflation. Europe risks becoming another Japan.

Q: What about what's happening in the U.S.?

A: For now the Congress is behaving well, because they're off on vacation, but what happens when they come back and we have to deal with spending bills and debt ceilings over the coming year? It could be "deja view all over again," and a government shutdown or a threatened default on our debt could be destabilizing.

Q: Is there any good news out there?

A: The U.S. economy is growing. Gross Domestic Product seems to be growing close to 3 percent, and I think the year from the fourth quarter of last year through the final quarter of this year will be up about 2.7 percent.

Also, our unemployment rate is close to 6 percent. We seem to be able to sell automobiles. Consumer balance sheets seem to be in pretty good shape. That shows we should be able to do OK if these tropical depressions don't become hurricanes.

As for next year, against this backdrop GDP could be a little less than 3 percent.

Q: Inflation seems to be low, so does this help keep interest rates low for a while?

A: It depends on what "a while" means. The fed funds rate should stay as low as it is today until next summer, then rise gradually so that as you get into the middle of 2015 it might be a percentage point higher than today, but that's pretty low.

Meanwhile, long-term interest rates on the 10-year Treasury note, now around 2.5 percent, may be 3 percent at the end of the year and may cost 4 percent at the end of 2015, higher than today but low by any yardstick.

Q: But is a bond bubble growing?

A: As interest rates rise and bond prices fall going from 2.5 percent to 4 percent will reduce the value of Treasury bond holdings, so it is a bubble of sorts. But what's very different about this bubble compared to the dot-com bubble is that Treasury bonds will always hold face value if you hold them to maturity.

If you're worried about a bond bubble, you should reduce the maturity of your bond portfolio, because the shorter the maturity the lower the sensitivity to rising rates.

Q: What about the Federal Reserve's intention to raise rates?

A: Let's hope the Fed can multi-task, because they're having to simultaneously wind down quantitative easing and go back to raising short-term interest rates. This is not easy. Too much and short-term and long-term rates will rise too quickly. And too little, and financial markets will feel that the Fed is getting behind the inflation curve.

In the past interest rate cycles, the Fed has only had to worry about short-term interest rates. Now it has to worry about how quantitative easing will affect long-term rates.

Q: Is the job situation getting murky because of the latest rise in initial unemployment claims and the fact that wages and hours aren't increasing and the new jobs aren't the same as before the recession and aren't as good?

A: This is a major concern of Fed chief Janet Yellen and other Fed members. This concern is a reason why the Fed is likely to err on the side of caution in raising interest rates. The scenario of holding off until the middle of next year is a cautious scenario. Those who are more concerned about inflation would like to see the Fed raise rates sooner, but that won't happen unless we get signs that wages start rising rapidly, loan demand picks up substantially, and now, and the economy becomes much stronger

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