Expect tricky year for bonds

The Fed's expected end to its 18-month campaign to hike interest rates means good news for stocks, but a more volatile bond market and a resumed slide in the U.S. dollar.

The release last week of the Federal Reserve's minutes from its Dec. 13 meeting set off a stock market rally that experts believe will continue throughout the year, although many expect the economy to slow downin the second half of 2006.

The flip side is that lack of a clear direction for interest rates introduces lots of uncertainty into the bond market. "This will probably be the trickiest year for bond investing this decade," said Jeffrey Gundlach, chief investment officer of TCW Group Inc., Los Angeles.

The anticipated halt in the federal funds rate increases — expected to plateau at either 4.5% or 4.75% — also means the Feb. 1 transition of the Fed's chairmanship to Bernard Bernanke from the 18-year tenure of Alan Greenspan is expected to proceed seamlessly. "Greenspan has orchestrated a nice handoff to Bernanke," said Bruce Harley, head of U.S. government derivatives for INVESCO Inc., Louisville, Ky.

The Fed had already signaled its intent to bring its seemingly relentless increases in the federal funds rate to a close following the Dec. 13 Federal Open Market Committee meeting. Since June 2003, the rate had steadily moved up to 4.25% from a 46-year low of 1%. In a December release, the Fed said interest rate policy was no longer "accommodative" — that is, interest rates were no longer bolstering the economy and instead had reached a neutral level.

But the stock market needed further clarification that the rate hikes were over. That confirmation came Jan. 3 when the minutes were released, resulting in a 2% two-day gain in the Standard & Poor's 500 index.

For the stock market, the end of rate hikes spells huge relief, because many investors tend to shift money to higher-yielding investments.

"The prospect of never-ending Fed tightening has hurt the stock market, particularly large-cap stocks," said Paul McCulley, managing director and portfolio manager at Pacific Investment Management Co., Newport Beach, Calif.

"Equity markets don't like high rates," said Milton Ezrati, senior economist at Lord Abbett & Co. LLC, Jersey City, N.J.

Strong corporate earnings and cash flows and more reasonable stock valuations have put U.S. companies in a good position. Large-cap growth stocks in particular stand to benefit in the latter stages of an investment cycle, Mr. Ezrati explained. "When growth becomes scarcer, people will pay a premium for it."

Meanwhile, investors' renewed interest in receiving dividends favors large-cap stocks over smaller-cap stocks, he said. Plus, small-cap and midcap stock valuations have surged in the past few years, making them less attractive.

Mr. Ezrati favors commodities-based stocks and industrials, including technology stocks, going forward. He declined to mention stock names because of company policy.

Jim Swanson, chief investment strategist for MFS Investment Management Inc., Boston, agrees that small-cap stocks will no longer lead the market. Smaller companies are more dependent on bank loans to meet borrowing needs, and that cost of capital has been rising, he said. He thinks oil-service companies, pharmaceutical and biotechnology stocks will perform well.

However, James Paulsen, chief investment strategist for Wells Capital Management Inc., Minneapolis, thinks small-cap stocks still have a lot of room left to grow.

He thinks the Fed built up interest rates to 4.25% from 1% largely to eliminate "an emergency panicky discount" put in place to calm twitchy markets. Normally, after such a lengthy period of tightening, a liquidity crisis occurs, real interest rates are high, stock market prices suffer and commodity prices fall. But none of those situations has occurred, he said.

What's more, the government has pumped $400 billion into the economy through deficit spending. Both monetary and fiscal policies "remain stimulative, not restrictive," Mr. Paulsen said. "So the surprise this year is the economy won't slow" and might even get stronger, he predicted.

Those conditions boost small-cap and cyclical stocks. Mr. Paulsen thinks technology, manufacturing and retail stocks will perform best in 2006.

For bonds, the outlook is far murkier.

For the first time in years, Fed watchers have no clear idea which way the Fed will go with interest rates. Bond investors have had a clear path since 2001, first when the Fed cut rates in response to the end of the tech-stock bubble and the Sept. 11 terrorist attacks, and again in 2003, when the Fed decided it was time to head off inflationary threats by raising rates.

"Three, four, five months ago, everybody knew the pattern. Here's the (Fed) statement. You knew they would go up 25 basis points every meeting," INVESCO's Mr. Harley said. The result was that the bond market became less reactive to key economic data such as unemployment figures, he said.

Now, the Fed will respond much more to market news. "We're going from being on autopilot with the Fed to being more data-dependent," Mr. Harley said.

In the short term, the news that the rate hikes have ended has dropped yields to the 4.3% to 4.4% range, from more than 4.5%. The range between two- and 10-year Treasury bonds, which had briefly inverted, is shifting back to a positive relationship, said PIMCO's Mr. McCulley.

"For the bond market, it's a ‘good news' as well as a ‘bad news' story. The unwinding has been a source of strength in the past few weeks, but you don't get to go to heaven twice for the same good deed," Mr. McCulley said.

Longer term, PIMCO officials believe the yield curve will steepen and the economy will slow. They think tighter Fed policy is already slowing the housing market, ending consumer reliance on adjustable-rate and interest-only mortgages. Borrowing against homeowner equity has enabled U.S. consumers to live beyond their means, Mr. McCulley and his colleagues believe.

The resulting slowdown will hurt corporate bonds, where spreads are already tight. PIMCO is overweighting mortgage-backed securities and has extended duration slightly in U.S. bonds.

Similarly, TCW's Mr. Grundlach thinks the economy will slow to a 2% real rate, down from quarterly growth rates ranging between 3.3% and 4.1% in the first nine months of 2005. He is also overweighting mortgage-backed securities and is heavy on Treasuries. Now that the flattening yield curve is reversing, it's time to reinvest in intermediate bonds, he said.

But the challenges for bond investors this year are daunting. Interest rates are uncertain; the carry trade, where investors make money by lending money at low short-term rates and borrowing at high rates, is gone; and the cheapest sector is modestly performing mortgage-backed securities, Mr. Grundlach added.