Going Up?

Federal Reserve Chairman Alan Greenspan may have been sending President George Bush a message last month when the Fed chief tossed election-year etiquette aside and signaled that he might raise interest rates soon. A rate hike this year would surely slow any job recovery and hurt Bush on the campaign trail. But Greenspan hates budget deficits, and Bush has pushed the U.S.'s to a record $521 billion.

So, was it economics that prompted Greenspan to rescind his pledge to keep rates low "for a considerable period"? In so doing, he may reverse key trends in the bond and stock markets and the dollar. Or was it election-year politics--"Give me what I want, or else"? Greenspan has pulled the rate lever to political end before. In Maestro, author Bob Woodward portrays the Fed chief's decision to hold rates steady in 1993 (while inflation was rising) as tossing a bone to a young Clinton Administration, which at Greenspan's behest had set aggressive deficit-reduction goals.

"Does the Fed consider the budget in setting monetary policy?" asks Donald Straszheim, president of Straszheim Global Advisors in Santa Monica, Calif. "I sure hope so." Deficits restrain spending and push up long-term interest rates. That makes them worthy of the Fed's consideration, Straszheim says. Besides, election-year etiquette, which holds that the Fed should sit on its hands during campaign season, is more myth than reality. In six of the past 10 presidential-election years, the Fed has raised rates.

Which brings us to this year. Whether motivated by politics (to get Bush's attention on the deficit) or pure economics (growth is back; inflation lurks), Greenspan seems bent on raising rates sooner than expected. He backpedaled in testimony last week. But his new posture gives him room to move and leaves investors to ponder some big changes:

HIGHER LONG-TERM RATES In theory, when the Fed raises short-term rates, the bond market should be reassured that the Fed is vigilant on inflation. Bond traders, who hate inflation because it erodes the value of their fixed-interest payments, should be happy and refrain from pushing yields higher. But the reality is that traders tend to fret that the Fed is too late, that inflation is baked in. So they send yields higher (and prices lower) as compensation for the additional risk.

This is no time to own a lot of Treasury bonds, unless they're the inflation-protected variety, known as TIPs. Corporate bonds are similarly vulnerable. That includes junk bonds, which often resist forces that push up other bond yields. But yields on junk have fallen so low in the past 12 months that they would probably rise as well, saddling investors with losses or disappointing gains.

A FIRM DOLLAR Many believe the buck, which slumped 17% against the euro last year, will continue to weaken as the U.S. government keeps spending money it doesn't have. Yet rising interest rates attract foreign investment and often buoy the dollar, which firmed noticeably after Greenspan's rate signal in late January. The buck may hold firm if, as seems logical, Europe cuts interest rates to combat slow growth. A steady dollar would remove the currency edge of foreign securities, which in dollar terms rose nearly twice as much as they did in local currencies last year. You should favor U.S. assets. As a hedge, hold some European stock or bond funds, which as rates decline overseas could rally sharply. Consider Mutual European or Fidelity Europe Capital Appreciation, which have been top performers over the past three and five years. Credit Suisse Global Fixed Income has been a stellar bond fund over the past five years.

THE RETURN OF RISK AVERSION After Greenspan's rate signal, speculative investments like emerging markets and small stocks stumbled. "This may be the inflection point, where investors decide that risk is no longer a one-way bet," says Tom Gallagher, an analyst for ISI Group. Last year stocks of companies that lost money rose 132%, while those of companies that posted a profit rose just 43%. Rising rates have a way of dampening speculation and should bring safety (and sanity) back into focus. So stick with blue chips that pay a dividend. The Dodge & Cox Stock Fund is a long-run winner. And let the Fed worry about politics. Or not.