US bond and equity holders look to Fed

By Michael Mackenzie in New York

www.FT.com

Updated: 3:41 p.m. MT Oct 2, 2006

The past three months have been profitable for investors holding US equities and government bonds, but this bullish coupling also highlights a debate over the US economy's likely performance next year.

The outlook depends on whether a hard or soft landing beckons, something closely linked to the fate of the housing market. The size of the US economy means that the outcome has major implications for global growth and markets.

Both stocks and bonds have benefited from the Federal Reserve deciding not to raise interest rates further since the end of June and the sharp decline in oil prices from record levels in July.

In turn, lower long-term interest rates have reduced mortgage costs, duly boosting equity investors' hopes that the consumer can weather further weakness in the housing market.

The S&P 500 index has risen 5.2 per cent during the third quarter - its best quarterly performance since the fourth quarter of 2004 - and is up 7 per cent for the year to date.

Lehman Brothers' US Treasury index has gained 3.68 per cent since June 30, outpacing a gain for the year to date of 2.34 per cent, the best quarterly return since the third quarter of 2002.

The current interplay between stocks and rates has been a feature in recent years. "Every time this has happened, stock prices ultimately make new highs and Treasury yields also reach new highs," said Jim Paulsen, chief investment strategist at Wells Capital Management. His view suggests Treasury prices may fall as the threat of a hard landing recedes.

With the Dow Jones stock index near its record high, it appears equity valuations are pricing in a soft landing with growth taking off again in six to nine months.

According to Alan Ruskin, chief international strategist at RBS Greenwich Capital, "Markets are also flirting with the idea that we are now approaching the equivalent of that mid 1995 period, when the Fed successfully soft-landed the economy and set in train a prolonged recovery."

For now, holders of Treasuries are focusing upon the present slowdown in growth, with some believing housing weakness will spread and could engulf the broader economy. As a result they anticipate rate cuts during 2007, and market yields remain well below the Fed funds rate of 5.25 per cent.

"The jury is still out on whether the weaker housing market undercuts the wider economy," said Jane Caron, chief economic strategist at Dwight Asset Management.

"If the consumer can show strength during the fourth quarter, it begs the question as to why the Fed would cut rates.''

One market influenced by both the level of rates and expectations for company profits is the world of corporate bonds and credit derivatives. Here, spreads, or risk premiums, are near historic lows, suggesting investors believe the economic outlook is benign.
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