FINANCIAL MARKETS : Stocks, Bonds Rally on Fed Action

Treasury bond yields plunged and stock prices soared Tuesday after the Federal Reserve Board steeply raised two short-term interest rates.

While the Fed’s action was expected, many market strategists were pleasantly surprised by its aggressiveness, which loudly signaled resolve to keep inflation in check.

By day’s end, the yield on the Treasury’s bellwether 30-year bond had fallen to 7.36% from Monday’s 7.50%. Its price, which moves in the opposite direction, jumped 1 23/32 point, or $17.19 per $1,000 in face value.

On Wall Street, the Dow Jones industrial average rose 24.28 to 3,784.57.

The Treasury market rally was further fueled by the Fed’s suggestion that it would leave rates alone for now. It said in a statement that “these actions are expected to be sufficient, at least for a time.”

The notion that rates would hold steady, at least for a time, lifted a great uncertainty from investors in fixed-income securities, who make profits by trying to predict the future course of interest rates.

In a message from its Open Market Committee policy group meeting in Washington, the Fed said it was raising the benchmark federal funds rate, which banks charge each other on overnight loans, to 4.75% from 4.25%.

The discount rate, which the Fed charges on its own loans, was raised to 4% from 3.5%.

Many market participants had expected the Fed to raise the federal funds rate by only one-quarter point.

But sentiment that the Fed would decide on more aggressive hikes seemed to prevail before the Fed’s 2 p.m. announcement. Prices of long-term bonds were up sharply in early trading, indicating that traders were betting on the bigger increase.

The half-point move made a strong anti-inflationary statement because higher rates increase borrowing costs and tend to help slow consumer and business spending--and curtail economic growth before it grows inflationary.

Fixed-income investors welcome prospects of low inflation because bonds tend to be eroded in value by higher prices in the general economy.

“It was a sign the Fed means business when it comes to fighting inflation,” said Ed McKelvey, senior economist at Goldman, Sachs & Co.

Prices of short-term issues rose 5/32 point to 9/32 point and intermediate maturities rose 19/32 point to 1 3/32 point, the Telerate Inc. financial information service reported.

The Lehman Bros. Daily Treasury Bond Index, reflecting price movements on bonds with maturities of a year or longer, rose 7.51 to 1,218.38.

On Wall Street, broad-market indexes posted healthy gains as well. The NYSE’s composite index rose 1.73 to 256.25. The American Stock Exchange’s market value index rose 0.34 to 443.66. The Nasdaq composite index of mostly smaller companies rose 2.62 to 735.51.

On the New York Stock Exchange, advancing issues outnumbered declining ones about 11 to 8. Big Board volume totaled a robust 304.47 million shares, up from 223.57 million shares traded Monday.

The Dow was hovering nearly unchanged at about 1:15 p.m., when the much-anticipated message came: the Fed had increased the two key rates.

The news sent the Dow shooting upward as much as 20 points from its opening level. Computerized “sell” programs quickly kicked in, sending the Dow plunging 40 points within 10 minutes, but after the “sell” activity was over the Dow regained its footing and sprinted higher.

Before the rate increases, some analysts had expressed concern that higher interest rates, by raising corporate borrowing costs, could choke off the economic recovery, compromise corporate earnings and send stock prices lower.

But on Tuesday, analysts said the economy and corporate profits were strong enough to withstand the higher short-term rates.

“You may see some weakening in residential construction activity . . . but you’re not going to get a severe weakening in the overall economy as a result of where interest rates are right now,” said James Solloway, research director at Argus Research Corp.

With second-quarter earnings reports as strong as they were, “Stocks can withstand this latest move, especially since the bond market has reacted fairly well to it,” Solloway said.

Among the market highlights:

* Pharmaceutical issues gained on takeover speculation. Merck was the most active stocks on the NYSE actives, rising 3/4 to 33 7/8.

* Another takeover candidate, American Cyanamid, rose 3 1/8 to 94 on speculation about the company’s response to a $100-per-share offer from American Home Products.

* Home Depot rose 2 3/8 to 44 3/8 after posting stronger-than-expected second-quarter earnings.

* Growth stocks, which tend to perform well during times of rising interest rates, gained on Tuesday. PepsiCo, for example, rose 1 1/4 to 32 3/8. Economically sensitive stocks did well also, with General Motors up 1 1/8 to 51, Ford up 7/8 to 30 1/2, and Caterpillar up 2 5/8 to 108 7/8. And interest-sensitive stocks performed well, too. Chemical Bank rose 3/4 to 39 1/8.

Overseas, stocks were higher, with Mexico City’s Bolsa index gained 43.10, or 1.63%, to 2694.60, its highest level since reaching 2684.14 on Feb. 21.

In Tokyo, the Nikkei 225-share average closed at 20,786.36, up 160.03 points. Frankfurt’s 30-share DAX average ended 4.30 points higher, at 2,143.14; London’s Financial Times 100-share average rose 5.2 points to 3,147.4.

Meanwhile, the dollar ended only modestly higher in volatile dealings.

In New York, the dollar was quoted at 1.559 German marks, up from 1.552 marks on Monday. The dollar closed at 100.40 Japanese yen, up from 100.13 yen on Monday.