Shorter-Term Rates Anticipate Fed Tightening

Another jump in shorter-term market interest rates suggests a growing conviction that the Federal Reserve Board will tighten credit soon, as the U.S. economy continues to expand.

Shorter-term rates, such as on U.S. Treasury bills and notes, would be directly affected by an official Fed rate increase. Until recently, bill and note yields appeared to be stabilizing after surging in early spring.

But over the last two weeks, shorter-term yields have risen markedly, as more investors have apparently become convinced that the economy has enough momentum to warrant tighter credit:

* Three- and six-month T-bill yields reached 5.23% and 5.43%, respectively, at Monday’s weekly Treasury auction, up from 5.16% and 5.35% a week earlier and the highest since late last year.

* The yield on one-year T-bills was 5.76% at Tuesday’s market close, up nearly a quarter of a percentage point just since May 22. The yield was at 4.82% in early February, before the economy rebounded.

While many investors pay attention to long-term bond yields--such as on the 30-year Treasury issue--longer-term yields are theoretically more sensitive to expectations for inflation than to changes in the Fed’s official short-term rates.

The bellwether 30-year T-bond yield, at 7% on Tuesday, is no higher than it was in early May, suggesting no major change in the inflation outlook since then. But the steady rise in shorter-term rates since early May signals that more investors are preparing for a Fed rate hike--just one year after the Fed began lowering rates.

The Fed’s most recent move was to cut its benchmark short-term interest rate, the federal funds rate, to 5.25% from 5.5% on Jan. 31. But since then the economy’s resilience has surprised nearly everyone. And Fed officials lately have hinted that the time may be nearing when they must raise rates to keep the economy from growing too fast and fueling higher inflation. Last week, in particular, “various Fed officials [said] in essence that the central bank stands ready to tighten policy fairly soon unless the economy begins to show signs of slowing,” said John R. Williams, economist at Bankers Trust in New York.

An important statistic on the economy’s pace is due Friday: the government’s report on May job growth. So far this year, the monthly jobs report has mostly pointed to a healthier-than-expected economy, stoking concerns about inflation and interest rates.

On Tuesday, Fed Gov. Lawrence Lindsey added to the chorus of talking Fed-heads, saying that while he thinks the economy is “moving ahead at a moderate pace . . . we are in an environment where one should be very cautious. We are in a kind of a situation where one might expect inflation . . . but again we are not observing it.”

Even as shorter-term market rates rise, appearing to anticipate a Fed rate boost, many economists doubt that the central bank will act at its next meeting, which takes place July 2-3. A Reuters poll of 30 economists this week shows 29 say the Fed will stand pat at the July meeting.

“My bet is they don’t raise rates” at the next meeting, said Irwin Kellner, economist at Chase Regional Bank in New York.

*

Kellner argues that the economy’s strength has been overstated this year and that consumer spending will run out of steam in the second half because of burdensome debt levels, still-slow income growth and higher mortgage rates. In terms of slowing the economy, “the bond market has done the Fed’s job for it already” thanks to higher interest rates, he said.

What’s more, analysts note that the abrupt plunge in grain prices over the last few weeks--after they hit record highs in early spring on Midwest weather woes--will give the Fed more comfort about overall inflation remaining tame, in the 3%-per-year range. Likewise, the drop in oil prices from April peaks should help restrain inflation worries, some say.

But then, why have investors continued to demand higher short-term rates in recent weeks? Robert Brusca, economist at Nikko Securities in New York, believes that Kellner and others who are counting on a slowing economy are getting it wrong, just as they have been wrong about the economy’s strength so far this year. “The market is trying to come to grips with what the economy is doing,” Brusca said. “And I think the economy is doing better and will continue to do better.”

Business activity has good momentum, he said, and higher interest rates haven’t been enough to halt consumer spending or stop business capital spending in its tracks.

While Brusca agrees that the Fed probably won’t change rates at its July meeting, he thinks the central bank will raise rates a quarter of a percentage point at the August meeting, and again before year’s end, putting the federal funds rate at 5.75% by the beginning of 1997.

Many investors have come to believe that the Fed doesn’t raise interest rates in election years, but in fact it did so in both 1984 and 1988.

The key, Brusca says, is that before Fed Chairman Alan Greenspan and his board will inject a tighter credit policy into the election debate, “they have to be clear about what they’re doing and why.” That’s why the Fed is likely to wait until August, Brusca says: to gather more evidence that the economy is growing at a decent pace and that inflationary pressures inherent in that pace--especially growing upward pressure on wages--warrant slightly higher interest rates.

Of course, there is still the chance that Brusca is wrong and Kellner is right. Just because the bond market is telegraphing a Fed rate hike doesn’t mean it will happen. Indeed, the market has had an amazingly poor record of predicting the economy and the Fed for the last two years.

For now, a key issue is how long-term bonds, and the stock market, will react if shorter-term rates continue to rise, betting on a Fed rate hike sometime in the next few months. The bond market knows that “usually when the Fed changes direction, it keeps going” in that direction for a while, notes Bank of America Senior Vice President Kirk Hartman. So if more bond investors come to expect a Fed rate boost, they may expect a series of them--and long-term bond yields may have to rise in lock-step with short-term rates.

The stock bull market, meanwhile, has barely been affected by higher interest rates so far. Rising short-term rates, however, will make bank savings certificates and money market funds slightly more attractive. And history says a tighter Fed is one of the stock market’s worst enemies--unless investors can convince themselves that any rate hikes will be over quickly, and will guarantee another “soft landing” for the economy.

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Nervous Market

Shorter-term interest rates have jumped in recent weeks on fresh signs of economic growth. The yield on one-year Treasury bills, weekly closes and latest:

Tuesday: 5.76%

Source: Bloomberg Business News