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Storytelling In The News: #121

Inflation and the story of money

April 16, 2004

The most important story on Wall Street these days is not whether but when? When will the Fed move up interest rates. The destiny of hundreds of billion dollars depends on which story is told.

Lingering concerns about deflation felt by investors were allayed last week after the government reported brisk March retail sales and the biggest surge in consumer prices in more than two years.

The story that inflation was on the rise roiled the bond market, where expectations of a Federal Reserve rate increase and concerns about inflation have combined to push longer-term interest rates up more than half a percentage point since mid-March.

Many investors see the story of the economy as having reached a turning point, with the recovery on a self-sustaining path but facing a period of adjustment as investors, companies and households confront the implications of a world without cheap money.

Managing that adjustment falls to the Fed, which for a year has been saying that the primary fears were slow growth and price deflation, not inflation.

The issue isn't whether prices are rising so fast that the Fed needs to step on the monetary brake -- they're not -- but whether it's finally time to begin easing off the accelerator, in the form of the lowest federal funds rate in 46 years. Just the process of moving the Fed to a "neutral" position would involve increasing the funds rates from 1 percent to 3 percent. And last week the message from the bond market and a growing number of economists is that the time to begin moving in that direction is at hand.

The stakes for financial markets of this story are profound. Over the past year, hedge funds, banks and speculators have borrowed heavily to buy stocks, bonds, real estate and commodities, helping to drive up prices of those assets and leaving markets vulnerable to any backup in rates. Now that rates have indeed begun to rise, the danger is that there could be such a rush to unwind those positions that these asset bubbles could burst. Just such a panic was reflected in the sharp decline last week in the share prices of once-hot real estate investment trusts.

Perhaps even more important than where to go in equities is simply to trim back exposure to bonds. Jim Paulsen, chief investment officer at Wells Capital Management in Minneapolis spoke to the Wall Street Journal. "The bond market bores you to death – then it kills you," he said. He thinks the Fed-funds rate could reach 2.5% to 3% by the end of the year, and that the 10-year yield will hit 5.5% by the end of the year – a steep increase from 4.34%, where it stands as of Friday. "I think the best thing you can do as an investor is reduce your bond exposure and reduce the duration of remaining bond exposure," he says.

Historically, bonds do much worse than stocks when inflation is rising, Paulsen says, citing 1984 and 1994 as two years of inflation fears when bonds got killed and stocks held up better – even if that meant staying flat for awhile. In 1984, the 30-year bond's yield soared from 10% to 14% as bond prices tumbled. In 1994, the yield rose from 6% to 8.5%. In both cases, he says, stocks were almost completely flat for the year and saw big gains in the years following.

Investors are also beginning to cast a nervous eye on China's overheated economy. While China's appetite for goods and capital is helping to fuel economic growth around the world, it is also driving up world prices for everything from cement to soybeans. But cooling things down would require Beijing to untether its currency from the dollar, which risks destabilizing China's already frail banking system and slowing its transition to a market economy.

Bottom line

Thus, investors sit watching, in part constructing their own story of the likely path of the economy, but even more important, trying to figure out what story other players will follow - the Fed, other investors and analysts - will concoct. The choice of story will have a determining impact on the placyment of hundred billions of dollars.

Read The Wall Street Journal

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