Stocks -- REITs rally as broader market declines
Now that the Fed has raised its key overnight lending rate by an as-expected quarter of a percentage point, a major source of uncertainty is behind us. (The Federal Funds Rate is the rate banks charge each other for overnight loans.) The markets also breathed a sigh of relief as the Fed governors announced they would raise rates at a “measured” pace, allowing the economy to continue strengthening.

Markets rallied strongly on the day of the Fed’s June 30th announcement, but the rally quickly fizzled as an uncertain economic outlook weighed on stocks. For the first two weeks of July disappointing earnings reports from the tech sector, weak economic data, rising oil prices and renewed terrorist concerns all combined to keep investors on the sidelines. As a result, the market took on a bearish tone and the S&P 500 index closed -2.5% lower between June 30th and July 14th.

The Dow Jones Dividend Index reflected the broader market averages, but dropped less sharply. The index closed at 633.95, down -1.3% during the same time period. Meanwhile, the real estate sector continued to strengthen in the face of a market decline. The Dow Jones Equity REIT Index actually rose by 12 basis points to finish at 190.81 on Wednesday evening.

Bonds -- Bond markets tread water ahead of inflation reports
Following the Fed rate hike, banks raised their prime lending rate by a quarter of a percentage point to 4.25%. Although the prime rate influences consumer borrowing rates for everything from credit cards to personal loans, consumers should feel little impact, according to the American Bankers Association. The cost to consumers of a quarter percentage point rate hike is about $2.50 a year on $1,000 of debt -- less than the cost of a latte!

The rate hike also triggered a short-term spike in the returns on bank deposit products such as CDs (certificates of deposit), savings accounts, and money market accounts. The average yield on three-month CDs rose to 1.56% on June 29-30th, but retreated to 1.51% the next day.

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Bonds turned higher and their yields fell sharply after the Fed confirmed it would raise interest rates at a “measured” pace. Yields on the benchmark 10-year Treasury, used in setting mortgage and corporate lending rates, fell from a two-year high in mid-June of 4.87% to a two-month low of 4.41% in early July. Bonds remained largely unchanged during the first two weeks of July as traders waited for a clearer reading on the inflation outlook. (Rising inflation erodes the value of bonds, leading to lower prices and higher yields.) Bonds declined slightly on July 14th and yields gained ahead of key inflation reports due later in the week. Looking back at the last few weeks, yields on the 10-year Treasury have fallen 14 basis points from June 30th, closing at 4.48% on July 14th. 

Over the past two weeks, as the yield on 10-year Treasury notes has slipped, the slope between the two-year and 10-year Treasury notes has continued to flatten. The flattened yield curve is an indication that the markets are treading water until they have a clearer sense of the economic and inflationary outlook.

Outlook -- Dividends set to grow as profits increase
In the coming weeks, Wall Street will be watching closely for any signs of inflation. The pace of inflation will influence future interest rate decisions by the Federal Reserve. The July 16th Consumer Price Index report and the second-quarter gross domestic product (GDP) numbers on July 30th are expected to signal how fast the economy is heating up. Right now, the financial markets are expecting inflation to proceed at a moderate pace and the Fed to raise the Fed Funds Rate a modest quarter of a percentage point at each of its next four meetings, reaching 2.25% by year-end.

Despite the recent spate of weak economic news, Kansas City Fed President Thomas Hoenig, a member of the Fed’s rate-setting committee, said he expected the economy to grow at a healthy 4.5% pace this year and for inflation to remain comfortably below 2%. That scenario would provide the best of all possible worlds for dividend-paying stocks. 

Fuelled by healthy corporate profits and reduced dividend taxes, a record number of companies have boosted their dividends this year. The first six months of 2004 saw the largest number of companies raising their dividends in any first-half-year period in the past five years, according to a Standard & Poor’s research report. Projecting a strong profit outlook, the research firm expects this rising dividend trend to continue for the balance of the year.

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