The Federal Reserve Board's 25-basis-point increase in the federal funds rate last week turned both stock and bond managers bearish, prompting a big drop in both stock and bond prices on Thursday.
The bond bears anticipated another interest rate hike in May, and perhaps more later.
They shortened the durations of their bond portfolios in the days following the hike.
The interest rate hike also put more pressure on the U.S. stock market, with some investment professionals reducing their stock exposure relative to bonds.
Though some fixed-income managers have a more positive outlook, others expect trouble.
"I think it's going to be a rough year," said Darrell Watters, portfolio manager for Janus Capital Corp., Denver. Janus expects three interest rate hikes of 25 basis points each, he said. Janus runs $5.7 billion in fixed income.
The economy appears to be fairly insensitive to the rate hikes, so it may take 50 more basis points to slow inflation pressures, he said.
In the bond market, there appears to be more danger on the downside than the upside, he said. A long bond rate of about 73/8% is "probably in the cards," he said. Long bond rates were just under 7% on March 26.
"We're really in a Catch-22," Mr. Watters said. The government should be running a surplus when the economy is running strong - instead it's still at a deficit. He wondered what will happen to the deficit when the economy begins to slow.
"The bond market needs to know they (the U.S. government) are serious about the budget. In my opinion, they're not."
As a result, Janus is shortening its durations and focusing on getting higher-yielding, higher-quality issues, he said.
Fixed-income managers at Van Kampen American Capital, Oakbrook Terrace, Ill., have been shortening durations too, said Peter W. Hegel, chief investment officer for fixed income.
And like many, Van Kampen managers expect at least one more rate increase. "I don't think 25 basis points is going to accomplish nearly what they want to accomplish," Mr. Hegel said. Van Kampen manages $31.2 billion in fixed income.
Van Kampen managers will look at any rallies in the short term as an opportunity to go shorter, he said.
Executives at Murray Johnstone International, Glasgow, also believe interest rates in general probably will rise, although they expect the fixed-income yield curve to remain relatively flat, said Rod Davidson, investment manager.
But from a global perspective, the U.S. bond market is a pretty good value, in part because of the expected strength seen in the U.S. dollar, Mr. Davidson said. Murray Johnstone manages $1 billion in fixed income.
Other fixed-income managers are more bullish on the U.S. bond market's prospects.
"We think the market is in pretty good shape," said Rob Kapito, vice chairman for BlackRock Financial Management, New York. Chairman Alan Greenspan gave investors plenty of signals that a hike was coming, and he followed through, Mr. Kapito said.
Seven percent on the long bond is an important level for fixed-income investors, including BlackRock. Any time long-term rates approach 7%, BlackRock managers will view that as a buying opportunity, Mr. Kapito said. BlackRock has $46 billion in fixed income under management.
Managers for Copernicus Asset Management, New York, also view 7% as a buying opportunity, said Didi Weinblatt, president and chief investment officer. In fact, she said it's possible that so many investors see 7% as a target, long rates may never reach that level. Copernicus, formed last year, has a very small amount of fixed income under management.
Michael A. Mullaney, senior investment strategist for Putnam Investments, Boston, said the market will be hard-pressed to go much higher than 7%, in part because investors have already priced another rate hike of about 29 basis points into fixed-income futures prices. Putnam manages $45 billion in bonds.
And market observers view the Fed move as one more reason for equity investors to be more concerned about where share prices are headed.
Donald G.M. Cox, chairman of Harris Investment Management Inc., Chicago, said the current Fed stance is one of the most restrictive in 20 years after taking into account inflation. Assuming that inflation has been overstated, as many claim, the real federal funds rate is 3.5%. HIM manages $2.9 billion in stocks and $6.3 billion in bonds and money market securities.
Mr. Cox expects a "severe slowdown" in the economy although not necessarily a recession. And while "stocks were overvalued collectively anyway," the rise in short-term rates and an accompanying rise in the U.S. dollar is going to hit smaller manufacturing companies especially hard, he said.
For example, Japanese auto makers were competitive with U.S. companies before the dollar's rise to about 124 yen. With the stronger dollar and higher interest rates,"it's like spotting the Green Bay Packers two touchdowns," Mr. Cox said.
Jim Griffin, senior vice president and investment strategist for Aeltus Investment Management Inc., Hartford, Conn., said the rate increase is one "warning signs" that the stock market could be feeling some downward pressure. Bond prices are relatively high, about 7%, and stock market gauges indicate prices are overvalued, he said.
Aeltus offers an asset allocation service that recently reduced its overweighting to stocks in favor of bonds. For most accounts, a neutral weighting would be 65% stocks and 35% bonds, Mr. Griffin said. Aeltus managers recently reduced accounts to close to a neutral weighting, he said. Aeltus manages $38 billion, about two-thirds of that in fixed income.
James Solloway, chief investment strategist and co-president of Argus Research Corp., a New York-based research firm, agrees a major market correction could occur, though "any drop is likely to be limited in both scope and duration." Mr. Solloway noted that in recent weeks, even minor market dips have brought "waves of new money" into the market as buyers seek to find value.
As a result, he said he's upbeat about the market. "But you still have to be careful where you are investing. . . . I'm upbeat about low p/e (stocks) and less highly valued parts of the market," he said.
"The rise in the (federal) funds rate shouldn't change the overall outlook for the equity market. It's not a grave blow to the overall market, but it will be harder now to make money in equities," Mr. Solloway said. "I'm not looking for the start of a bear market or any major systematic decline in stock prices, but there are valuation problems with large companies compared with smaller companies.
"There are no signs the market is entering a dangerous period anytime soon. . . . My inclination is to keep riding it until there are more signs that it is coming to an end. Right now it is hard to build a rational bearish scenario," he added.
Fred Williams contributed to this article.