Guessing Game Is On Over Fed Hikes

The Federal Reserve today is expected to make it a baker’s dozen with interest rate hikes, lifting its key short-term rate from 4% to 4.25%, the 13th increase since mid-2004.

For investors, savers, home buyers and others who have a big stake in Fed policy shifts, the focus now is on where the central bank is likely to stop.

Bill Gross, who manages the world’s largest bond mutual fund at Pacific Investment Management Co. in Newport Beach, is betting that the Fed will raise rates just once more after today -- to 4.5% in January.

Others believe that Gross is underestimating the potential for significantly higher rates in 2006. James Bianco, who heads bond-market research firm Bianco Research in Chicago, contends that there is no good reason for Fed policymakers to stop until they are “well over 5%” on their benchmark rate.

Correctly guessing the peak could be highly profitable for investors, of course. Many Wall Street pros believe that the stock market will rally sharply once the Fed is done tightening credit. For income-oriented investors, the smart move would be to lock in long-term bond yields or bank savings yields just as they’re cresting.

But picking a Fed interest rate peak has been a difficult game historically. And it may be more so this time because of the impending change at the top of the central bank: Alan Greenspan’s term as chairman will expire at the next meeting, on Jan. 31. Pending Senate confirmation, Ben S. Bernanke -- President Bush’s chief economic advisor -- will replace Greenspan.

The changeover could complicate the widespread assumption on Wall Street that the Fed will begin to signal when it is nearing the finish line, analysts say. That signal would be expected in the wording of the brief statement issued after each central bank meeting.

Some experts believe that the Fed could begin to tinker with that language in today’s statement, tilting just modestly toward the idea that rates may not need to rise much more. The risk, however, is that any signal from the Greenspan-led Fed might not reflect whatever views the Bernanke-led Fed comes to embrace.

“It may be premature to make a change” in the statement, said James Sarni, managing principal at Los Angeles investment firm Payden & Rygel, which manages about $54 billion, mostly in bond assets.

And because financial markets are so eager to believe that rates are topping out, there is great potential for any Fed language shift to be misinterpreted, some investment pros say.

“They have to think long and hard about changing the statement because people are going to hyper-extend whatever they say,” said Tad Rivelle, chief investment officer at Metropolitan West Asset Management in Los Angeles.

However today’s statement reads, it’s the strength of the economy and the trend in inflation that ultimately will determine where rates peak, analysts say. And some, such as Pimco’s Gross, believe that the U.S. economy soon will hit the brakes.

He expects the economy to slow to a 2% real growth rate in 2006, down sharply from this year’s expected range of 3.5% to 4%. Growth in the 2% range would be “sure to stop the Fed and to induce eventual [rate cuts] at some point later in the year,” Gross said in his November commentary on Pimco’s website.

Many analysts who share Gross’ relative pessimism about the economy -- and optimism about interest rates -- believe that the Treasury bond market is telegraphing much slower growth ahead.

In the lingo of the bond market, yields have “flattened”: The current annualized yield on a 10-year Treasury note, at 4.55%, isn’t much above the 4.43% yield on a two-year T-note. And neither is much above the Fed’s short-term rate, which is likely to be 4.25% by the end of today.

Historically, a pronounced flattening of bond yields often has been an indication that investors believed that the Fed was nearly done raising rates, and that the economy soon would slow.

But this time, other forces may be at work keeping U.S. bond yields down, analysts say. One factor often mentioned is robust demand for U.S. bonds by China’s central bank, as it invests the proceeds of its huge trade surplus.

Greenspan himself has warned Wall Street not to assume that the Fed would consider a flattening of bond yields to be a sign that the economy was about to weaken significantly, and therefore that the central bank should stop tightening credit.

Still, David Kelly, economist at Putnam Investments in Boston, agrees with Gross that a 4.50% rate should be “the upper limit” of what the Fed should do.

“I’m more worried about the economy slowing down too much” than about it speeding up, Kelly said.

Not so bond analyst Bianco, who contends that fears about the economy in 2006 are overblown. Recent data show growth has remained strong, he noted.

Although the Fed has been raising interest rates for 18 months, “Where is the pain in the economy?” he asked.

What’s more, the Fed knows it faces some major risks if it stops tightening credit too soon, Bianco said. The biggest risk is that Wall Street might doubt that the Fed was serious about fighting the inflation threat from near-record energy prices.

Because rising inflation erodes the returns of fixed-rate investments like bonds, investors might suddenly demand sharply higher long-term bond yields if they believed that inflation could worsen.

Another risk is that the dollar could plunge if foreign investors were to sour on U.S. bonds and short-term cash investments because they anticipated that yields wouldn’t rise much more.

Given the arguments on both sides, some analysts believe it would be safest for the Fed to seek a middle ground: moving its key rate to 4.75% by March, and then pausing to see how the economy fares.

“We think they’ll stop at 4.75% and see what happens,” said Eugenio Aleman, an economist at Wells Fargo & Co.