I saw a survey of fixed income investors earlier today that indicated the consensus is shifting from expecting three 0.25% increases in the Fed Funds rate during 2002 to four, one per quarter. Given that today’s overnight borrowing rate is effectively zero, this suggests a Fed Funds rate of 1.00% by yearend. If we were to make the much-too-simple assumption that rates would rise in lock step along the yield curve, this would imply a 10-year Treasury note at 2.75% in December.

Looking at rates from a different perspective, if we think the Fed’s ultimate goal is to have 2.0% inflation and a 100bp real yield on Treasuries, then the end point for the 10-year in the tightening/restoration of normal cycle we’re now starting would be a 3.0% yield.

At this juncture, the more important thing is not whether my figures are any more than generally close to accurate, but rather that interest rate policy has turned from a tailwind into a headwind for the stock market–and that things will stay this way for a considerable period of time. We’re at the beginning of the normalization process, not the end.

The immediate response of the stock market to rising interest rates is that the overall PE multiple contracts. The major offset to this is that earnings generally turn out to be stronger than expected, countering at least part of the downward pressure. Two, maybe three, issues, though. Perhaps the most important for us now is that the earnings are only reported quarterly, so the relief only comes through with a lag. Second, the companies that will show the strongest earnings growth aren’t necessarily the companies that have been the market darlings of the past year or two. Finally, I think the market tone will be dictated to a large degree by AI analyzing and reacting to the financial press. The people creating this content are relatively inexperienced and tend to reflect yesterday’s developments rather than anticipating tomorrow’s. I think this is likely to lengthen the time the market will spend discounting the fact of higher interest rates.

more on Monday