The Best of All Possible Worlds for Bonds

by: Barry Ritholtz

Today is a good time to consider this question: Which is better for stocks, falling rates, rising rates, or steady rates?

This is because Peter Boockvar of Miller Tabak writes this morn that:

Ahead of the 2 day FOMC meeting beginning tomorrow, the bond market has basically taken out any chance of a 1st half rate cut. Through year end, there is about a 60% chance that the Fed cuts once to 5%.

The answer, according to the Bulls quoted in the popular press, is all three:

As central-bank rate setters prepare for their first meeting of the year this week, investors increasingly are resigned to a longer pause in rate moves than previously expected.

Yet it might be that it is the pause that refreshes. In recent years, the stock market usually has performed well when the Fed declines to move up or down, as it has since last summer.

Some Wall Street forecasters say the Fed could go all year without changing its rate targets, a prospect that contributed to the market's sluggishness last week.

Such predictions run counter to many investors' hopes for a quick rate cut, which would lower borrowing costs and encourage more consumption throughout the U.S. economy, potentially helping corporate profits and thus stocks. (emphasis added)


Was it the Fed not moving rates this Summer that led to the sharp market rally? The massive complexity of the markets are why I never like to pick just one reason for any market behavior (see Single vs. Multiple Variable Analysis in Market Forecasts for more details). However, if gun-to-the-head I had to pick just one factor, it sure wouldn't be the Fed on hold. The GSCI energy exposure cuts, leading to a 30% drop in crude oil, coming on top of a major technically oversold condition in June would be the shortest explanation I could give.

But the FOMC on hold as the primary causation of the rally? pshaw.

The Fed pause is also recently credited with helping the greenback. CNN Money notes that:

After taking a beating last year, the dollar has steadied its course and could be poised for a lift as expectations for the Federal Reserve to cut rates fall by the wayside.

One of the themes we have heard relentlessly since the Fed paused was that rate cuts ere imminent. With no cuts on the horizon, that meme has morphed into the economy is strong enough not to require central bank loosening. Look for this to further morph into the net positives of rate hikes later this year: "If anything there is some risk the Fed may raise rates this year, if the current supply of relatively cheap money throughout the global financial system begins to translate into more inflation in the U.S." stated Ethan Harris , chief U.S. economist at Lehman Brothers (today's WSJ).

So there you have it in all of its Panglossian glory: If the Fed cuts rates, its good for stocks. The current rally was caused by the FOMC going on hold. And, more rate hikes are also good for stocks.

Voltaire's Candide had nothing on Wall Street: "All is for the best in the best of all possible worlds."

A Long Stretch of Steady Rates
Some Say Fed Could Go All Year Without Changing
Targets – And That May Be Good for Stocks
WSJ, January 29, 2007; Page C1

Extended Fed pause hopes boost dollar
As expectations for a Fed rate cut ease, greenback
could get a lift. But gains are likely to be limited, analysts say.
Grace Wong, January 25 2007: 12:16 PM EST