Big news in the fixed income market

Wednesday, June 8, 2005 at 1:00am

In the face of some talk about economic and earnings slowdowns, it seems that the equity markets finally got tired of going up, and ended last week slightly down. Markets were generally up for the week until Friday, when a weaker-than-expected non-farms payroll report for May caused a modest sell-off. For the week, the Dow Jones Industrial Average dropped 0.8 percent to close at 10,460 and the S&P 500 Index and Nasdaq Composite both declined by 0.2 percent to end the week at 1,196 and 2,071, respectively.

The big news from last week was in the fixed income market, as the yield on the 10-year Treasury (which moves in the opposite direction of prices) dropped below 4 percent. This fall was caused in part by comments from Richard Fisher, president of the Dallas Federal Reserve, who indicated that the Fed was in the "eighth inning" of its tightening cycle, and thus potentially near the end of increasing interest rates. The yield on the 10-year Treasury dropped as low as 3.83 percent on Friday morning before correcting in the face of selling pressures and ended the week at 3.98 percent, up from earlier in the day but still down for the week.

A number of factors have contributed to falling long-term interest rates, including moderating economic growth in the United States and around the world, continued heavy buying of Treasuries by foreign central banks and pension funds and bond investors who are looking for more stable opportunities in light of the uncertainties with the European Union and the euro. At the beginning of the year, we predicted that the yield on the 10-year Treasury would climb to 5 percent, and while that prediction is looking less and less certain, we do believe that current yields do not represent a great risk/reward tradeoff for investors. The yield on the 10-year bond bottomed at 3.1 percent in June 2003 and from that point has been following a "two steps forward, one step back" pattern. We believe that yields are still headed higher.

Investors are wondering if the Fed is close to finishing its tightening campaign and if that would be good or bad news for equities. From a current fed funds rate of 3 percent, the fed funds futures curve is currently forecasting a year-end rate of 3.5 percent, which is also what we have been predicting since the beginning of the year. Regarding what the conclusion of the tightening campaign might mean, the optimists believe that such a move would alleviate concerns that the Fed might go too far and cause weakness in the economy, while the pessimists believe that the economy may be weak already.

Our opinion is that when the Fed does stop increasing rates it will be good news and may help create an opportunity for some sort of equity market rally. A Fed that is sitting on the sidelines, however, likely will not be enough by itself to fuel a major equity market advance. A new bull market will probably require further declines in equity market risks, and with the possibility of slowing earnings in the second half of the year, a potential bubble in the housing market and some deflationary risks, such a move seems unlikely to occur, at least in the next few months.

Bob Doll is president and chief investment officer of Merrill Lynch Investment Managers. For more information on MLIM, e-mail mlim_feedback@ml.com.

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