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Here come higher rates
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January 3, 2000: 2:16 p.m. ET
Stock and bond investors now expect another interest rate hike next month
By Staff Writer M. Corey Goldman
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NEW YORK (CNNfn) - As if the alarm clock finally worked, the stock market woke up Monday to what the bond market has been claiming for months -- that the Federal Reserve isn’t finished raising interest rates in its bid to cool the economy and thwart inflation.
The bond market, which closed the books on its worst annual performance ever last week, began 2000 under a heavy weight, sinking almost two full points in the first few hours of trading. The 30-year benchmark bond’s yield, which moves inversely to the bond’s price, surged as high as 6.58 percent, the highest since September 1997.
Initially, U.S. stocks did what they’ve been doing for more than a year: They ignored bonds’ surging yields. After all, the traders waving their arms in the trading pits of Chicago have been wrongly betting for months that the new era of strong growth and low inflation would end.
Then, at mid-morning Monday, on the first trading day of the 21st Century, the stock market finally decided to stop and listen.
Re-focusing on the Fed
"With Y2K out of the way, people are focusing on the next Federal Reserve meeting, both equities and bonds,” said Mickey Levy, chief economist with Banc of America Securities. "The bond market is building in a lot of bad news and the stock market appears to be listening.”
U.S. stocks plunged. By midday, the Nasdaq composite fell 71.13, or 1.4 percent, to 3,998.18, before recovering to just 6 points on the positive side. The index had been up as much as 123 points. The Dow Jones industrial average declined 164.12, or 1.1 percent, to 11,333.00, and the S&P 500 index slid 28.99, or 1.7 percent, to 1,440.26.
At issue for Wall Street is the possibility of higher interest rates, which have become a major issue among investors.
Since Fed officials last raised short-term interest rates by a quarter point Nov. 16, bond investors have been betting that another rate rise will come in February, after all the Y2K glitches have worked their way out of the world’s computer systems.
Equity investors, too, had expected that some Y2K disruptions would slow the economy down and keep the Fed from tinkering with short-term rates. The Fed left its target rate for overnight bank lending unchanged at 5.5 percent at its Dec. 21 meeting.
Y2K did we get so excited?
They, along with millions of others worldwide, were more than surprised both New Year’s Day and today -- the first day of widespread computer use in the United States and many other countries in 2000 -- when nothing, repeat nothing, happened.
"People have long resisted the relationship between rising rates and the impact that may have on the economy and on equity valuations,” said Jack Malvey, a global fixed-income strategist with Lehman Brothers. "With Y2K out of the way, people are starting to realize that the economy is showing absolutely no signs of slowing down.”
Indeed, a report from the National Association of Purchasing Management released Monday indicated manufacturing activity, while declining, remains robust, and the prices purchasing managers are paying for the goods they need to make their stuff is rising.
But that was only part of the reason for the stock market’s swift about-face Monday. More significant was the global green light indicating the world’s financial markets were in tip-top shape to handle trading with triple zeros, followed shortly by the realization that the Fed no longer has a reason to hold the line on interest rates.
A free and clear Fed
"The Fed is now free to do whatever they need with the economy,” said Ian Shepherdson, chief U.S. economist with High Frequency Economics. "It’s largely the lack of any problems on Y2K which has people now expecting the Fed will take action.”
So what will the Fed do? According to the yield on the Fed funds futures contract that expires at the end of February, Fed policy makers are going to raise rates at least a quarter point at their next policy meeting. The rate currently is 5.81 percent, more than a quarter point above the current Fed funds rate of 5.5 percent.
The contract that expires in April, meanwhile, suggests a Fed funds target of 6 percent by the end of March, from either two separate quarter-point increases in February and March or from one big half-point increase at next month’s meeting.
Byron Wien, chief U.S. investment strategist with Morgan Stanley Dean Witter, said he expects the Fed will raise short-term rates by more than a full percentage point before the end of 2000.
More wage pressure, less productivity
"I think you'll see some wage pressures and less productivity improvements," contributing to higher prices for goods and services and possibly increased competition from other countries looking to sell their goods in the United States, Wien said.
As for the stock market, "I think ... there will be some erosion (like we're seeing today) ... but as we get more into it there will be some days of serious drops.”
Either way, stock and bond investors, along with economists and strategists, appear to have suddenly and definitively reached the same conclusion -- that the Fed will not allow the economy and the high-flying stock market to continue on its upward trajectory forever.
"The Fed more than likely would have moved in December had Y2K not been an issue,” Lehman’s Malvey said. "The bond market has felt for some time that higher rates would be needed to cool the economy, and while my expertise is not in equities, it does appear that they are finally listening.” 
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