Some Expect 2 Rate Hikes

Wall Street had been hoping for “none, or one and done” in terms of additional Federal Reserve interest rate increases. But a recent jump in yields on shorter-term Treasury securities suggests that investors are losing faith that the central bank is ready to take a break.

The outlook for rates will be center stage this week in financial markets as Ben S. Bernanke gives his first congressional testimony as Fed chairman.

Bernanke, who succeeded Alan Greenspan on Feb. 1, goes before the House Financial Services Committee on Wednesday and the Senate Banking Committee on Thursday, delivering the semiannual monetary policy report required by law.

The backdrop for his coming-out party is an increasingly nervous bond market, where investors last week pushed shorter-term Treasury security yields to the highest levels in five years -- delighting savers but threatening borrowers who have certain adjustable-rate loans.

The annualized yield on six-month T-bills hit 4.69% on Friday, up from 4.63% a week earlier and the highest since early 2001.

The two-year T-note yield ended Friday at 4.68%, up from 4.57% a week earlier and also the highest since 2001.

Short-term rates had stabilized in December and early January as more bond investors felt comfortable that the economy would slow and that the Fed soon would halt its 18-month-long credit-tightening campaign, which has lifted its key rate to 4.5% from 1%.

That optimism was reinforced Jan. 3, when the Fed released the minutes of its mid-December meeting. The minutes said policymakers believed that the number of additional rate increases “probably would not be large.”

Despite some recent signs of weakness in housing, however, many analysts believe that the economy overall remains on a healthy growth track -- healthy enough to justify at least two more Fed rate boosts, some say.

Jack Malvey, a fixed-income strategist at brokerage Lehman Bros. in New York, said he expected the Fed to raise its key rate to at least 5%, and perhaps 5.25%, before stopping.

The sudden jump in short-term Treasury yields in the last three weeks matches the market’s catch-up pattern during much of 2005, Malvey said: Many investors last year kept betting that the Fed was finished, only to face quarter-point rate hikes at every central bank meeting.

“The bond market for the last year has consistently underestimated the vigor of the U.S. economy,” Malvey said.

In the financial futures market, where investors bet on upcoming Fed rate changes, trading last week showed that investors believed that a quarter-point hike at the Fed’s March 28 meeting, to 4.75%, was a certainty.

More surprising is that the futures market now is leaning toward a hike at the mid-May meeting as well. That would bring the rate to 5%.

If that sentiment spreads, shorter-term Treasury yields are bound to head higher -- which means that savers might be better off waiting before locking in yields, financial advisors say.

At current levels, shorter-term Treasury yields “are barely positioned for one more rate hike that would stick,” let alone two or three hikes, said Lou Crandall, an economist at Wrightson ICAP in New York.

Meanwhile, for homeowners with a popular type of adjustable-rate mortgage that is pegged to one-year Treasury yields, every notch higher could spell bigger monthly payments come adjustment time.

The U.S. labor market may be key in shaping the Fed’s decisions on rates in coming months, economists say.

In recent weeks, the number of new claims for unemployment benefits hit a six-year low. That could point to strength in job creation and to a generally tightening labor market.

For the Fed, a relative shortage of labor could raise fears of an inflationary spiral if employers pay significantly more for workers and in turn pass that cost on to the buyers of their goods or services.

“The issue for Mr. Bernanke ... is whether a falling unemployment rate and rising wage gains mean that price inflation is likely to pick up,” said Edward Yardeni, an economist at investment firm Oak Associates in Akron, Ohio.

By continuing to raise rates, the Fed would be using its principal tool to slow consumption and damp inflation pressures.

On Capitol Hill this week, Bernanke is sure to face questions about his inflation outlook, the labor market and whether the Fed risks pushing the economy into recession if it continues to tighten credit.

And although most economists believe that Bernanke will speak more clearly than Greenspan -- who was famous for his verbal gymnastics -- they say it’s unlikely the new chief will allow his questioners to pin him down in terms of how close the Fed might be to ending its rate-raising campaign.

“While he probably will reiterate that further tightening ‘may be needed,’ there is no need for him to commit himself to anything at this point,” economists at Goldman Sachs & Co. said in a report to clients Friday.

Indeed, the Fed in recent months has made clear that its next moves with rates will depend on what the economic data show. And that means that policymakers themselves may not be sure where they’ll stop, analysts say.

Some economists are worried the Fed already has gone too far.

“I think they should pause now,” said Joseph Carson, an economist at Alliance Capital Management in New York.

He believes that many U.S. households are stretched financially because of heavy borrowing over the last few years, and that as a result consumer spending is bound to decelerate markedly this year.

Despite some data to the contrary, “I’m pretty convinced the economy is slowing down,” Carson said.

The Treasury bond market also is giving a classic sign that it expects a slowdown: Yields on longer-term securities have been below yields on shorter-term securities in recent months, a so-called rate inversion.

The 10-year Treasury note yield, for example, was 4.59% on Friday, 0.1 point less than the yield on six-month T-bills.

Normally, longer-term securities pay more. Historically, when inversions have occurred, they often have been preludes to economic weakness: Investors were willing to lock in less on longer-term securities because they figured all interest rates would be dropping soon because of a slowing economy.

This time, however, many on Wall Street say longer-term bond yields are being held down by pension funds and insurance companies worldwide that have voracious appetites for long-term, fixed-rate securities, as they seek to better match up their assets with what they’ll owe retiring baby boomers over the next few decades.

Case in point: The government last week sold new 30-year T-bonds at a yield of 4.53% -- well below yields on 10-year T-notes and those on shorter-term issues.