To judge by the shudders that have hit the markets lately, the effect of Federal Reserve moves to raise short-term interest rates is clear and simple.
Higher rates are bad news for both stocks and bonds. It's as straightforward as that: When the cost of money goes up, business feels the pinch. So does the supply of funds available to bid for securities, and so do the animal spirits that set the mood of financial marketplaces around the world.
Fed Chairman Alan Greenspan's words have an immediate impact on trading.
(Lucian Perkins -- The Washington Post)
Transcript: Washington Post reporter Ben White was online to answer questions about how inflation worries are influencing stock and mutual-fund performance.
The rule is easy to remember, even as the effects of higher interest rates ricochet through the system in a bewildering variety of ways.
What's the strange, ultra-sensitive connection between rising U.S. interest rates and stocks in emerging markets at the far corners of the world? Well, for one thing, higher rates cast a shadow on the so-called "carry trade," the common practice of speculators who borrow in the money markets to finance purchases of such things as Chinese or Eastern European or Latin American stocks.
So it could happen that from March 11 through March 23, a stretch of a mere eight trading days leading up to and including the latest increase by the Fed in the overnight money rate, the MSCI Emerging Markets Index tumbled 6.4 percent.
The effect on more developed markets was similar, though less extreme. The Standard & Poor's 500-stock index, dominated by big U.S. stocks, fell 2.3 percent.
The iShares Lehman Aggregate Bond Fund, an exchange-traded fund based on a popular measure of the bond market, dropped 0.45 percent in the same period. While that may look pretty innocuous at first glance, according to Bloomberg data it works out to a 12.9 percent loss at an annual rate.
That's not at all the sort of thing most conservative income-seeking investors have in mind when they venture into bonds. The damage can magnify many times over in the interest-rate futures markets and wherever else fast money trades in and out of bonds.
For all its high drama, our story so far leaves out an important part of the investing population. That would be the vast majority of long-term investors, as personified by the 93 million or so people who own mutual fund shares.
Should these people care whether the Fed keeps or drops the word "measured" in the next press release it issues describing its rate policy? How much do they need to worry whether the next increase in rates, presumably after the next policy meeting on May 3, will take federal funds up a quarter or a half of a percentage point, to 3 percent or 3.25 percent?
There's no question that Fed policy matters to everybody who holds financial assets, whatever the holding period. To the true long-term investor, however, the perspective can be very different from what the daily trader sees.
Hark back to October 1979, when the S&P 500 plunged 6.9 percent as the Fed, under new chairman Paul Volcker, raised rates from 11.5 percent to 15.5 percent in two giant steps.
As it turned out, Volcker's actions and that "October massacre" in stocks were helping to set the stage for a great bull market. Over the next 20 years, the S&P 500 soared 17.6 percent a year, turning each $1 invested at the beginning into $25 at the end.
The operative question wasn't where interest rates were headed next, or how high they had to go. It was whether the Fed would succeed in steering the economy out of the storms of high inflation and low growth into better times.
From past episodes such as this, a viewpoint suggests itself. It is long-term bullish if the Fed is doing the right thing for the economy, wherever its policy may take interest rates in the next few months.
Let's not pretend for a moment that it's easy to judge what constitutes the "right thing." If we are worried about a resurgence of inflation, we may be encouraged to see the Fed now acknowledging that "pressures on inflation have picked up in recent months," with the commitment to vigilance those words imply.
We still have to wonder whether that vigilance will ultimately produce good results, reining in inflation in a timely fashion without putting serious constraints on economic growth. But that's a very different matter from figuring out every flutter in interest rates.