Last Updated November 1998

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N EARLY SEPTEMBER, EVERYONE from Alan Greenspan to President Clinton was announcing that the U.S. economy was not an island of calm in the turbulent economic sea. You couldn't swing a dead cat without hitting some "expert" on CNBC or Wall Street Week proclaiming that the Fed had to move to ease interest rates or the U.S. would slide into recession -- or something worse.

The Fed accommodated with not one but two rate cuts. The first came in late September at their regularly scheduled meeting, the second came less than two weeks later. The markets had differing but generally favorable reactions. But was it enough or too little too late?

There's no question that the problems all around us are growing deeper. Japan still has no solution for its worsening banking problem. At this point, it looks like the solution lies in nothing less than the measures taken in this country in the late eighties to fix the savings and loan mess. However, Japanese officials evidently lack the backbone to take the necessary steps to move forward.

Elsewhere, Russia continues to teeter on the edge of bankruptcy. Brazil, the world's sixth largest economy desperately needs a monetary infusion. Canada, our largest trading partner, recently raised its bank rate by a full percentage point to 6%. This was done in effort to shore up the Canadian dollar. While it may succeed, tighter credit may push Canada into a recession by early 1999. With all this, it's no wonder everyone's worrying if the U.S. is next.

Lower Rates, Greater Volatility

The bond market however, took off. Spurred on not only by the cut in the Fed Funds rate, but also by the flight to quality from the sinking stock market and repercussions from the Long Term Capital debacle, the 30-year Treasury Bond approached 4.7%. This level hasn't been seen since 1967.

When the Fed subsequently cut the Fed Funds rate by another .25% and the Discount Rate by the same amount, the bond market actually fell. This probably had more to do with the weakening dollar than domestic interest rates. By late October, the long bond had gone back over 5%. Nevertheless, the yield may have further to fall in the short term.

Why? Well there's several factors. First, the Fed may not be (in fact probably isn't) done lowering rates. Some market watchers feel there may be as much as a full point ahead. This will certainly have a downward effect.

Secondly, even without further Fed action, there's probably still further room to fall. To see why, you have to look at how bond rates are determined. Essentially there are two factors: anticipated inflation and the real, riskless rate of return. These two components sum to the current bond yield.

Data from the 60s -- a period with economic conditions quite like the present -- indicate that the real, riskless rate of return for the 30-year government bond is approximately 2.75-3.00%. This is often reflected in the short-term Treasury Bill rate. The CPI is currently about 1.6% so a little simple math shows the long bond could easily be in the 4.35-4.60% range in the very near future. For bond investors this would be great. Heck with the problems in the stock market or international economies.

Help from Inflation?

As long as global recession remains a concern, inflation can continue at the present levels and possibly trend lower. Ironically, the most likely spark to higher inflation is the Fed itself if it overestimates the need for monetary stimulus and lowers rates too far. Remember, every Fed move takes between nine to twenty-four months to work its way through the economy. It could happen.

In the meantime, the mild divergence between the CPI (the cost of finished goods) and the PPI (the cost of raw materials) works in business' favor. The CPI has continued to climb at an almost imperceptible rate while the PPI has actually had several months of decline. This increased gap between the two provides additional margin to the companies selling finished goods. While they may not be able to increase profits by raising prices (bad) they can still increase profits if prices remain flat and the cost of raw materials fall (good). The weaker dollar may also help in this regard.

Earnings not Rates

Monetary policy is a tool to stabilize the economy and if used properly can keep it from sliding into recession. (This should also be true for fiscal policy as well, but it's more often than not simply a tool of the politicians.) Lower rates can stimulate growth by making capital more easily available. But low rates in and of themselves can't keep the economy growing. Only the growth provided by greater earnings a profits can do that.

If rates alone were sufficient, Japan's long-term rates around 1% would have its economy going through the ceiling. Fact is, it doesn't matter how low your rates are if no one wants to borrow. And why would anyone want to borrow to expand capacity if no one's buying their goods as it is?

(Economists used to refer to this as the "liquidity trap". It's one of those intelligent-sounding phrases you can throw in at one of those incredibly boring cocktail parties you'll get stuck in this holiday season. Use it to shut up Uncle Bill when he starts pontificating about his mutual funds.)

Fortunately consumer demand has held up well in the U.S. The results from the upcoming holiday season will provide a gauge for demand going into 1999. Many economists worry that with the falling equity markets, the U.S. consumer will curtail spending -- a negative "wealth effect". (Another cocktail party phrase -- take that, Uncle Bill!) In other words, when Americans look at their brokerage statements and see an actual loss, or look at their bank statement and realize their CD has renewed at 3.5%, they won't feel so affluent and will spend less. In essence, they may not spend us out of recession.

But there are other positives as we move towards 1999. Most third quarter earnings disappointments are already behind us. In fact, there's even been some positive surprises (e.g. Apple, Intel, Proctor & Gamble, etc.) in what many feel will be the near term low point for earnings.

As analysts and investors turn their attention to 1999, optimism (as it always does at the start of the year) will come back into the market. This sentiment should be bolstered by fourth quarter earnings. Remember, the final quarter of 1997 was when the Asian problem first surfaced so while this year's earnings may not set the world afire, they should still make for favorable comparisons. Additional rate cuts (or simply the belief there will be additional cuts) will also help propel the market through positive sentiment.

Looking into 1999, earnings may continue to slow, especially at the beginning of the year. Even so, the trends should still be up. The weakening dollar and any economic improvements abroad should help spur demand for U.S. products. Lower interest rates should assist the financial segment while tech stocks will benefit from reduced inventories. Healthcare will probably continue to see steady demand as more products come to market. Consolidation should help propel the depressed biotech segment.

The market may already be forming a base from which to resume its upward trend (see How Can I Tell When the Bear Is Gone?). The recent leadership of small and mid-cap stocks is also a good sign. While lower interest rates will help all market segments, it's the small-caps that stand to benefit the most. Bull markets start with improving earnings and investor confidence in more than just the bluest of the blue chips. Rate cuts can get this going, but the Fed can't pull it off alone.