Broker Talk: When the Feds Leave the Building

With the Federal government planning its “exit strategy” from its various interventions in the financial markets, investors are pondering the fate of long-term interest rates. Will rising rates make stocks more or less attractive than bonds? These brokerages weigh in.

Who’s Talking: The Wells Fargo Economic Group

The Gist: Long-term interest rates are headed up, but the impact on the economy depends on the political response.

Governor of the Bank of England Mervyn King’s recent guidance to investors on the direction of long-term interest rates was that they’re on their way up. The Wells Fargo Economic Group says it agrees for the following four reasons.

First, investors’ economic expectations will push credit demand upward, as the supply of credit shifts to riskier assets. Meanwhile, Treasury debt will drop in tandem. Second, as demand for Treasury debt subsides, both from the Fed and from investors, the supply of debt will increase, especially since the Federal deficit is expanding. Third, a declining dollar will also increase the risk of buying U.S. dollar denominated assets, the group says. Right now, the Treasury Department seems to lack interest in shifting public policy to boost the dollar value and is instead exercising its “benign neglect,” the group says.

The last reason for the rise of long-term interest rates will be the interplay between monetary and fiscal policy. The Federal Reserve will attempt to exit the bond market and by the end of October will discontinue its purchases of Treasury debt. By March 2010, the Fed will discontinue the purchase of mortgage-backed securities asset-backed securities as part of its “exit strategy,” says the group.

So, the question is: how much will interest rates rise without the Fed’s support? It all depends on the political response to the economy, the group says. It isn’t clear how much interest rates will impact the economy yet or how much interest rate hikes will alter mortgage and consumer lending rates. No matter what the exit strategy, though, the group says the government’s moves will create a political “tug-of-war” that forces a balancing act between the Fed’s independence and the political pressure to relieve the jobs market.

Who’s Talking: David Bianco, Chief U.S. Equity Strategist for Bank of America/Merrill Lynch

The Gist: Dividend yields look increasingly attractive compared to interest rates, making stocks with above-market earnings yields and dividend yields more appealing than bonds.

David Bianco says now is the time to buy stock in companies with attractive earnings yields, dividend yields and more than 35% of business in foreign markets. The “relative attractiveness of stocks versus bonds is close to a 40-year high,” he says. Stocks are even attractive when comparing dividend yields to the yields on Treasury Inflation Protected Securities, or TIPS.

So what should investors buy? Bianco recommends staples that offer a mix of growth and income. Stocks with dividend yields at or above the Standard & Poor 500’s 2.2% yield are preferable, but it is important to take into consideration the safety of the dividend and its growth potential, he says. The best sector to find dividend income is utilities, since its high dividend yield (4.5%) is double the market’s. Plus, low interest rates could lure yield-seeking investors out of fixed-income products and into stocks. Utilities may also offer more stable prices than benchmark Treasury bonds, which are affected by currency volatility, he says.

Investors might be worried that stocks will look less attractive than bonds once dividend tax cuts expire at the end of 2010. That may be true, says Bianco, but it’s doubtful that the dividend tax rate will get to the same level as the income tax rate. Dividend taxes will probably be capped at the capital gains tax rate, which would mean investing in stocks would still have tax advantages over investing in bonds (the interest on which is taxed as income).