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While You're Waiting . . .

March 25, 1997|TOM PETRUNO

If he doesn't raise interest rates today, Alan Greenspan should get an Academy Award: Best Fake-Out Performance by a Federal Reserve Board chairman.

Greenspan's numerous recent warnings about the need to be "preemptive" against inflation guarantee at least a quarter-point rate boost when the central bank meets, most Wall Streeters believe.

And then what? That is the financial markets' most vexing question. Unless you employ a truly talented psychic, in the near term investors who are mulling whether to buy, sell or hold stocks or bonds will have to pick a Fed/markets scenario they're comfortable with and invest--or not--accordingly.

For now, Wall Street certainly seems braced for bad news. In fact, a rise in the Fed's benchmark short-term rate, the so-called federal funds rate, from the current 5.25% has become so widely anticipated--driving stock prices down and bond yields up in recent weeks--that markets actually rallied Monday.

The Dow Jones industrials soared 100.46 points to 6,905.25 and bond yields eased, in what some analysts saw as an attempt by investors to front-run any "relief rally" that could occur today if indeed the Fed finally acts, tightening credit for the first time in more than two years.

But figuring out Greenspan & Co., and markets' likely reactions to the central bank's attempts to fine-tune the economy via interest rates, is rarely a simple exercise, especially when the Fed is making money tighter rather than looser.

For investors and savers, the direction of stock prices, bond yields and bank savings rates in the near term will depend not so much on the Fed's actions today, but what it does in ensuing months.

Here's a look at the potential implications of a Fed tightening move for various markets, and what investors should consider as they weigh buy and sell decisions in coming months:

* U.S. stocks:

Many investors know instinctively that a stingier Fed is almost always bad for stock prices. By definition, when the Fed is raising rates it is trying to slow the economy by removing some of the grease--that is, money--that makes business and markets go.

The last time the Fed was in tightening mode was in 1994. Between February 1994 and February 1995, the central bank doubled the federal funds rate--the rate banks charge each other for overnight loans--from 3% to 6%.

The Fed's first rate increase in that cycle was just a quarter of a point, on Feb. 4, 1994. But Wall Street was so stunned that the Dow industrials plunged 96.24 points, or 2.4%, to 3,871.42 that day.

The decline continued, erratically, until early April, shaving nearly 10% from the Dow. And for the rest of 1994, stocks were under pressure as the Fed continued to tighten. The Dow gained just 2.1% for the full year, and most broader stock indexes were down between 2% and 9% in 1994.


This time around, however, no one is going to be surprised by a Fed rate increase. Partly in anticipation of such a move, the Dow is down 2.5% from its March 11 record high. And most broader stock indexes have fallen much more: The Nasdaq composite index of mostly smaller stocks has already plunged 10.5% from its record high set on Jan. 22.

Does that mean a quarter-point rate hike is already factored into stocks' prices? Maybe. But many Wall Street pros believe that soon after today's rate increase, assuming it occurs, investors will focus on the bigger question: How much more tightening will the Fed do before it decides the economy is slowing enough to keep inflationary pressures at bay?

"I think the immediate refrain [on Wall Street] is going to be, 'There's more to come,' " said Jeffrey Applegate, market strategist at Lehman Bros. in New York. And that, he said, is likely to mean further downward pressure on stocks, slicing as much as 10% off the Dow in coming months.

Charles Pradilla, strategist at Cowen & Co. in New York, says the good news is that, with its benchmark short-term rate already at 5.25% (versus just 3% in 1994), "the Fed will not have to go into a prolonged series of rate increases" to achieve its desired goal.

On that most pros agree. Still, will Greenspan want a half-point rate boost in all, meaning a quarter-point now and another quarter at the Fed's May 20 meeting? Will it take three-quarters of a point?

Pradilla figures that until "Greenspan's final agenda is clear, or until the economy slows, we're still in a correction" in stocks--historically, the normal reaction to higher interest rates.

If there's one thing that could make investors try to forget about the Fed, however, it's corporate earnings. If first-quarter earnings reports, which will begin to flow in mid-April, are better than expected, many pros say the market could lift off again.

But that's also the big risk. If earnings fall short of expectations, stocks will have not just one, but two serious strikes against them, Applegate notes.

* Foreign stocks.

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