Cole Porter confessed that he received no kick from champagne. Even alcohol delivered no thrill. The stock market is equally unmoved by a different and decidedly negative tonic known as interest rates. Bulls of earlier generations felt differently. The question is whether today’s optimists can maintain their cheery outlook even in the face of a more determined assault from a bond market that’s newly inspired to reprice and revalue?
In particular, the benchmark 10-year Treasury Note closed above 5% yesterday for the first time since June 2002. If that was a warning shot across the stock market’s bow, it was a minor milestone received with a flurry of buy orders among equity traders. Although the S&P 500 has slumped this week, it managed to eke out a small gain yesterday even as the 10-year yield crossed north of 5%.
Year-to-date, the S&P 500’s price is higher by 3.3%. Meanwhile, the small-cap S&P 600 is up an impressive 10.5% so far in 2006. Perhaps the stock market dreams of bulls conjured by comments like those espoused by Fed Board Governor Donald Kohn. Yesterday, he suggested in a speech that the central bank’s recent monetary tightening may suffer from irrational exuberance as it tries to restrain the effects of excess liquidity that the Fed unleashed a few years earlier. “Overshooting is one of the things we are very aware of as a risk in policy today,” Kohn said on Thursday in a response to a question after a speech, reports Reuters.
Risky or not, the Fed is now enthused about cutting off any emerging inflationary pressures in the bud. Whatever the risk of going overboard with rate hikes, for the moment they seem to pale next to the hazards that some think could ensue by ending the monetary tightening. The futures market, for one, all but predicts that the 25-basis-point hikes will continue in coming months, in which case the current 4.75% Fed funds would elevate to 5.25% and perhaps beyond. If so, the bond market, now that it’s found monetary religion, presumably would keep pushing the 10-year higher. Flat yield curves, it seems, are in danger of becoming déclassé among the fashionably minded fixed-income set this season.