The Federal Reserve may have been tight-lipped about interest rates this week, but it had something to say about debt. The minutes of the last meeting of the Federal Reserve’s Open Market Committee released Tuesday and Fed Chairman Ben Bernanke’s own remarks Wednesday afternoon included warnings about the dangers of a high federal deficit and a call to reduce spending or risk weakening the nation’s prospects for raising the capital necessary to stay solvent. Weak demand for U.S. government debt during the last few Treasury sales has helped fuel those worries. Some investors worried that more lackluster 10-year Treasury note auctions could lead to a protracted uptick in borrowing costs.

However, something unexpected happened on Wednesday that quelled many of those fears. The government’s latest auction saw the strongest bidding for 10-year Treasurys in more than a decade. All of a sudden, U.S. debt looked popular again. (Meanwhile on Wall Street, the U.S. stock market rallied. For the first time since the early days of the financial crisis, the Dow Jones Industrial Average appears to be within striking distance of 11000.)
Such a robust showing at the Treasury auction was particularly surprising after Greek bond prices had plunged early in the week. For years, economists have been preaching about the interconnectivity of the global economy, yet this week, a country whose debt crisis sent shockwaves through the euro zone seemed to hold little sway with American investors. Could it be that the outcome of the Greek drama isn’t all that important to the outlook for the earnings of U.S. stocks — or stocks anywhere else in the world, with the exception of Greece? Here’s what two brokers had to say:

Who’s Talking: Ed Yardeni, President and Chief Investment Strategist, Yardeni Research

The Gist: As more indicators suggest that the global economy is booming again, Greece appears to be more of an outlier.

The yield on Greek 10-year government bonds jumped more than half a percentage point to 7.1% on Tuesday, after a news report suggested Greece wanted to change the terms of its bailout deal. The report said Greece wanted to exclude the International Monetary Fund (IMF) from an aid plan it recently agreed to with the IMF and European Union. The subtext is that country was concerned the IMF would initiate harsh policies in exchange for assistance. Although Greece’s finance minister George Papaconstantinou denied the report, the fear of contagion remains heightened. If bond investors become reluctant to buy Greek debt or demand even higher interest rates, the EU may need to bolster its commitment to a bailout. Otherwise, it could risk greater currency losses, Yardeni says.

Although Greece’s drama triggered a dip in the euro on Tuesday, the U.S. stock market appeared unaffected. That’s a trend that likely to continue no matter what fate befalls Greece, says Yardeni. “This has to be the longest Greek drama ever performed,” he says. “It will end eventually without any major tragedy for the U.S. stock market, in my opinion.”

So what will affect the U.S. market? If the Fed holds its key interest rate close to zero for an extended period, as it has indicated on several occasions, companies in the financial sector could see their earnings jump by 88.7%, Yardeni says. “Even better would be to see nonperforming loans decline, which is the most likely scenario over the rest of the year,” he says.

In addition, discretionary consumer spending should continue to outperform, as employment expands over the year. Analysts focused on the sector expect a 127.8% rebound in earnings during the first quarter of this year compared to 2009. That’s good news for retailers, restaurants and even auto stocks, he says. However, the bad news for those companies is that former Fed Chairman Paul Volcker endorsed a value added tax this week on products in those sectors to help reduce the federal deficit, he says.

Who’s Talking: Francois Trahan, Vice Chairman, Head of Portfolio Strategy and Quantitative Research, Wolfe Trahan & Co.

The Gist: Although Greece remains the poster child for “emerging market” troubles today, not all emerging markets are connected – and not all of them are struggling in the same way. In fact, quite independently of Greece’s situation, the developing countries in Asia look like good bets in 2010.

In 2009, the recovery abroad was similar to that of the U.S., says Trahan. Most countries saw their leading indicators recover in a V-shaped pattern as they did in the U.S. And although some European nations saw their recoveries kick in sooner than the U.S.’s, some of those rebounds were fleeting. “By late 2009, some countries saw an early end to their rise in leading indicators, while others continued to climb,” he says.

Now, as European stimulus efforts fade, individual countries’ risks have become more visible, Trahan says. Today, the countries that maintain the highest perceived default risk are those with the loosest monetary policies or the widest trade deficits, he says. “Years of explosive money supply expansion and current account deficits are now being exposed as the stimulus bandages come off. There remain deep secular issues that cyclical policies (i.e., stimulus) are unlikely to remedy,” Trahan says.

Meanwhile, the recoveries in China and South Korea have remained robust. Although China’s exports fell 16% in 2009, the country’s early recovery helped stimulate several other economies in the developing world. For example, record gains in many gauges of domestic demand, such as vehicle sales and home-price appreciation, in China likely helped propel South Korea to its fastest industrial production growth rate since 1976, says Trahan. China’s ability to expand its economy by 8.7% last year without a contribution from exports is telling, he says. Will Chinese exports see a resurgence this year? Trahan says yes.

From the Brokers: Links to Broker Sites and Research

Ameriprise Financial Barclays Charles Schwab
DWS (Deutsche Bank) Edward Jones Fidelity
J.P. Morgan Merrill Lynch Morgan Stanley
Raymond James T. Rowe Price Wachovia Securities

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