Analysts Keeping Close Watch on Interest Rates

NEW YORK – Investors are nervous and the stock market shows it; for every step forward, it seems to take three back. And despite relatively strong corporate earnings, a decent jobs picture and red-hot housing market, investors still worry about the possibility of a prolonged "soft patch."

Meanwhile, analysts are warily watching the yields on Treasury notes and bonds, wondering what signals to read into their range-bound moves as the Federal Reserve (search) is expected to raise overnight borrowing costs again on Tuesday. If the policy makers act as expected, they'll hike the federal funds rate by 25 basis points to 3.0 percent. It will be the eighth such increase since the Fed began tightening credit in June 2004.

During that time, yields on long bonds have remained in a stubborn range, essentially going nowhere even as short-term rates rise. For example, the yield on the 10-year Treasury note was 4.25 percent at the start of 2004; it ended the year at 4.22 percent, and now stands at 4.20 percent — though just last month it climbed to 4.6 percent.

"Interest rates today are lower than they were when the Fed began this exercise of raising interest rates. It's really dumbfounding," said Margie Patel (search), senior vice president of Pioneer Investments (search) and manager of four fund portfolios. "Despite people's fondest hopes and wishes for much higher Treasury rates, they've been very disappointed."

To Patel, what that suggests is that despite upswings in commodity prices, the long-term outlook for inflation is fairly muted. Investors seem quite comfortable with intermediate Treasury yields in the range where they are, and she doesn't think they'll go substantially higher for a while.

To Jeff Kleintop, chief investment strategist for PNC Financial Services Group (search) in Philadelphia, the message the bond market has been sending is clear: Economic growth is slowing, and slowing dramatically. This has alarmed stock investors, whose sense of panic about the state of the economy has grown as negative data points pile higher.

Bonds rose and stocks dropped this past week on news that the nation's gross domestic product rose at an annual rate of 3.1 percent during the January-to-March period, a disappointment because economists had forecast a faster 3.5 percent pace. High energy prices and cutbacks in consumer and business spending were blamed. Still, analysts, including Patel and Kleintop, note that GDP growth of about 3.0 is considered average.

Of course, that's not the only thing that has made market watchers bearish lately; a number of signs suggested March was the start of a softer period for economic data. Retail sales were less than stellar. Auto sales were sluggish. Orders for durable goods plunged 2.8 percent, the biggest drop in 2 1/2 years, which suggested a strong pullback in business spending. Analysts attributed the disappointments to soaring fuel costs, chilly weather and, in the case of retail sales, an early Easter holiday.

And yet there was some good news. Purchases of new single-family homes shot up 12.2 percent in March, the biggest percentage gain in more than a decade. The surge surprised analysts, who had forecast a decline in sales.

The labor market is somewhat murkier; employers added just 110,000 new jobs in March, the fewest in eight months. Analysts say the employment report for April, due next week, may show only modestly higher gains. But some have speculated that the government's numbers don't accurately reflect the strength of the job market.

"Certainly we've had a rough patch of data," Kleintop said. "It'll be interesting to see from the Fed's perspective if was it just a one month thing ... if they see the trend as one of more solid growth. And if the economic data bounces back, yields could go back up."

Such a bifurcation in economic data can be confusing, even for professional investors. Kleintop, who thinks the bond market has overreacted, said the wording of next week's Fed statement could help reverse the trend.

"It could be enough to turn the bond market around," he said. "Hopefully it could be a catalyst for stocks as well, to make investors say, 'Yeah, real growth isn't that bad, the economy isn't slowing that much.' And hopefully companies can continue to hit their earnings targets and investors will have better confidence the companies can deliver."

If, for example, the Fed issues a statement saying the pace of economic growth has remained solid through the recent volatility, that would suggest policy makers see the recent data as a short-term blip. That could lead bonds to sell off, bringing yields higher. If they maintain language from their February statement that said "longer-term inflation expectations remain well contained," so much the better.

"There's so much volatility in the market," Kleintop said, noting how closely Wall Street (search) examines statements from the Fed. "A word can move the markets a lot."

For Patel, one of the most important things is for the Fed to clearly telegraph its intentions. When the Fed is inscrutable, it is difficult for businesses to make long-term decisions, because they don't know what's happening with the economy.

"The reason interest rates move up off their lows is because there's greater demand to borrow because businesses feel more optimistic about the economy. And key to that is a Fed that is predictable, moving incrementally," Patel said. "Slightly higher rates would not be a negative for the economy or for equities. It would be a sign that the economy is improving in its health."