Friday, April 01, 2005

Interest rate hikes now making an impact

The Dallas Morning News

By Danielle DiMartino

Until recently, someone returning from long travels wouldn't have guessed that the Federal Reserve was on a campaign to raise interest rates.

The Fed began raising its short-term interest rates last June, but the 10-year Treasury yield dropped only to around 4 percent, closer to its historic post-Sept. 11 lows.

Finally, in February, worries about inflation, foreign investors' appetite for U.S. dollars, faster job growth and the Fed's long-term intentions combined to launch the 10-year yield half a percentage point in a month, into the 4.5 percent range.

That hammered the price of existing bonds, on the theory that new bond issues' higher yields would be more valuable to investors.

Now many experts are contemplating a 5 percent yield, which hasn't been seen since June 10, 2002. That would take bond investors out of the comfort zone they've enjoyed for three years.

"If you start to get above 5 percent on the 10-year, this complacency could rock people, because we've been in this range for so long," said Kathleen Bostjancic, senior U.S. economist at Merrill Lynch.

Fueling speculation on a new range for the 10-year was the Fed's statement March 22 that it sees inflation risks as having risen, implying that more interest rate hikes are ahead.

The Fed has raised its key short-term rate seven times in quarter-point increments since last June, from 1 percent to 2.75 percent. The futures market is predicting an increase of an additional 1.25 points by the end of the year, to 4 percent.

And that, most agree, will finally push the yield on the 10-year Treasury back above 5 percent.

But there is less accord on whether the Fed will stay the course. The problem is the connection between long-term interest rates and the housing market.

In the minutes from its February meeting, the Fed acknowledged the risks to the economy associated with the current speculative fervor in housing.

"The Fed is caught in this dilemma similar to 1999 when they were afraid to raise rates because of the equity bubble," Bostjancic said. "They don't want to burst the housing bubble, but they certainly don't want to keep building it up either."

That's why the Fed is searching for Goldilocks, said Mark Kiesel, portfolio manager at Pimco, the giant of bond funds. If the Fed can find the right spot, it could well engineer a soft landing for interest rates.

To that end, Kiesel figures the Fed funds rate will end the year at 3.5 percent, below the futures market's expectations.

That would translate into a ceiling of 5 percent on the 10-year Treasury, and the range of the last three years would again prevail.

"We've seen this before _ whenever the yield on the 10-year approaches 5 percent, the economy slows," Kiesel said. "That's why we see a constant range on the 10-year yield of between 4 percent and 5 percent."

In the meantime, investors can relish the fact that interest paid on their cash is finally surpassing inflation, if measured against the core consumer price index, currently running at a 2.3 percent annualized rate.

"There are a lot of happy retirees out there who can finally get a decent yield for their money," said Ken Buntrock, co-head of fixed income at Loomis Sayles.

He cites six-month, two-year and three-year rates that have doubled in the last year.

"If you're risk-averse, go into short-term Treasuries and wait for the next entry point to come along," he said.

Kiesel and Buntrock agree that "entry point" for longer-term bonds will coincide with the 10-year approaching 5 percent.