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Wall St. Bets on a 'Soft Landing'--and Maybe More

September 03, 2000|TOM PETRUNO

The Federal Reserve may not yet be convinced that an economic "soft landing" is underway, but Wall Street seems to believe it's chiseled in granite.

In fact, some investors appear to be confidently assuming that the Fed, which now is in a cautious holding pattern with interest rates, will soon be cutting rates to keep the economy from slowing too sharply.

That's an assumption that is far too gleeful, some analysts contend. But given financial markets' penchant for overreaction this year, a few more convincing signs of economic slowing could easily cause a mad rush to the Fed-will-soon-ease side of the boat.

On Friday, Treasury bond yields slid to their lowest levels in at least nine months after the government said the unemployment rate rose slightly in August and after a trade group of corporate purchasing managers said manufacturing activity nationwide declined in August after 18 months of growth.

The stock market--which is, of course, genetically programmed to rally on news of falling interest rates--on Friday extended what has been an impressive advance over the last five weeks.

The Nasdaq composite index jumped 4.7% for the week to end Friday at 4,234.33, nearing the midsummer peak of 4,274.67 reached July 17, as the tech-stock machine revved up again.

The blue-chip Standard & Poor's 500 rose 0.9% for the week and is a mere 0.5% move away from topping its record high close of 1,527.46 set March 24.

If you've been on summer vacation and haven't paid much attention to stocks' whereabouts, you may be surprised at just how much progress has been made in the last month or so. The Nasdaq index has surged 15.6% in five weeks, turning red ink to black: The index now is up 4.1% year to date.

The S&P 500 has risen 7.1% in five weeks and is up 3.5% for the year.

And unlike the trend of the first half of the year, when wild market volatility was the rule rather than the exception, the last five weeks have witnessed a slow but steady advance that has included a broad cross-section of stocks.

The Nasdaq, S&P and Dow industrial indexes all have risen for five consecutive weeks--a hat trick that last occurred in early 1998, according to Bloomberg News statisticians.

"I think the markets are seeing [the economic data] as having 'soft landing' written all over it," said James Glassman, economist at Chase Securities in New York.

Soft landing, in Fed speak, means the economy is slowing enough to eliminate the need for the Fed to further raise interest rates to dampen activity--but not enough to threaten a recession, which is what we get when the economy contracts instead of expands.

Let's assume there is a soft landing underway, even though the Fed has continued to warn that it still can't be sure that its yearlong campaign of tightening credit has done the trick.

What happens in a soft landing? A key element is a slowdown in spending by many consumers and businesses. And if there's less spending going on, that's obviously a direct threat to the sales and earnings of many companies.

So far, however, the specter of an earnings slowdown doesn't seem to be registering in much of the stock market, with the glaring exception of the retail sector.

Will investors care if corporate earnings growth in fact slows markedly? Maybe not--at least, not if the Fed begins cutting interest rates. If we can still believe the finance textbooks, lower rates should automatically make stocks more attractive investments relative to bonds and money market alternatives.

What's more, a rate-cutting Federal Reserve would be sending the one message that resonates loudest on Wall Street: "We're going to make sure everything's OK."

Scott Grannis, economist at Western Asset Management in Pasadena, believes that the economic evidence already dictates that there is "no chance the Fed will tighten credit again. . . . And I think they're getting close to easing."

The decline in longer-term bond yields over the last two months is clearing the way for the Fed, Grannis says. Should the yield on the two-year Treasury note, now at 6.07%, fall under 6%, that would be a powerful signal that the Fed's benchmark overnight interest rate--currently 6.5%--is too high and threatens a dangerously deep economic slowdown, Grannis contends.

But many other market veterans aren't so sure the Fed will, or should, begin cutting rates soon.

Inflationary pressures, particularly from still-rising energy prices, haven't dissipated significantly if at all, argues Paul Kasriel, economist at Northern Trust in Chicago.

On Friday, the Commodity Research Bureau/Bridge index of 17 key commodity prices hit a fresh two-year high, mainly driven (again) by energy.

"Inflation tends to be a lagging economic process," Kasriel notes. And that means the next few months could present a disconcerting combination: higher inflation amid generally weaker economic data.

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