Bucking the consensus, economists from prominent Wall Street firms are predicting sharp tightening of U.S. monetary policy, starting possibly as early as July.
Such a move probably would damage bond prices and could hurt stocks.
Because the Federal Reserve Board did not tighten credit availability at its May Federal Open Market Committee -following its March tightening - interest is growing in upcoming Fed meetings. The committee next meets July 1-2.
Many in the market expect relatively modest tightening, at most hikes of 25 basis points to 50 basis points in the Federal funds rate this year. But some prominent bears see more dramatic action:
Economist David Greenlaw with Morgan Stanley Dean Witter, sees tightening in stages that should lift the Fed funds rate 100 basis points to 6.5% by year's end. Because of the strong economy, inflation pressure "will become more evident in the second half of the year," he predicted.
David Hensley, economist with Salomon Brothers Inc., expects a "series of moves that would put the Fed funds rate as high as 6.5% by year's end." In his view, the "preconditions for inflation are in the labor market."
William Dudley, U.S. economic research director of Goldman, Sachs & Co., forecasts two stages of tightening. The first will be an increase of 50 basis points in the Fed funds rate by the end of September. Then, next year, when inflation becomes more visible, Fed funds will rise by another 50 basis points, bringing it to 6.5% by midyear 1998.
Topping even those forecasts, Joseph Lavorgne, financial markets economist with Deutsche Morgan Grenfell Inc., foresees the Fed funds rising to about 7.25% in 1998. That would follow two 25-basis point hikes this year, followed by another 75 basis points of tightening next year.
"We're seeing wage growth running ahead of inflation on a sustained basis, for the first time since the mid-1970s," explained Mr. Lavorgne.
Because workers "are getting more of the economic pie, they have more money to purchase goods and services. . . . They will keep purchasing . . . until rates are high enough to make the cost of borrowing meaningful."
This means "the bond market's days are numbered," Mr. Lavorgne said. And, because stock prices also could suffer from higher interest rates, he thinks investors should "be in cash and wait things out."
For its part, Goldman, Sachs, while cautious about bonds, is less concerned about the stock market. While the equity market isn't likely to replicate gains of the past couple of years, returns still should outstrip those from cash, Mr. Dudley said.
And investors themselves are not running for cover. With money managers' predictions ranging from no Fed tightening ahead to comparatively modest rate hikes, managers are not unloading portfolios. While some have opted for shorter fixed-income maturities lately, others have looked for buying opportunities in bonds.
John Paul Isaacson, chief investment officer of Payden & Rygel, Los Angeles, suspects the Fed will raise interest rates 50 basis points over the course of its next three meetings. The firm's response is to be defensive, but much more so on the shorter-end of the spectrum. (As of Jan. 1, Payden & Rygel had $16.8 billion of U.S. institutional tax-exempt assets under management, of which 98% was in fixed income.)
However, John B. Brynjolfsson, vice president of Pacific Investment Management Co., Newport Beach, Calif., doesn't believe "the Fed has to tighten at all. Inflation is very muted and is poised to stay there for the next three to five years."
Right now, durations of his bond portfolios are slightly longer than their benchmarks. Although he became a "little defensive" after the Fed tightening in March, which meant bringing durations back to neutral, he has since "extended them out a little bit." (At the beginning of this year, PIMCO had nearly $82 billion of U.S. institutional tax-exempt assets under management, more than 80% of that in fixed income.)
Mr. Brynjolfsson acknowledges the bond market "has priced in at least one more Fed tightening before year's end." But if that does happen, he believes his investments won't suffer.
In fact, he sees market gains ahead. "The risk is that, going forward, the market will realize that less, not more, tightening, is (in order), causing it to rally."
The differing opinions about the markets, and Fed tightening, stem from divergent views about the economy. While many expected a cooling off in the second quarter after the first quarter's 5.6% growth on an annual basis, some argue too small of a slowdown might have occurred to prevent inflation. Strong employment is certainly a key concern. But even in this area, data so far haven't been conclusive.
For example, while "inflation appears to be docile at the moment, there are clouds on the horizon," said Louis A. Holland, managing partner and chief investment officer of Holland Capital Management, Chicago. He cited concerns about the employment cost index, noting that, after bottoming out, the wage portion of that index has trended up slightly, and prior declines in its benefits component have flattened out recently. These trends suggest a possible rise in the overall employment cost index.
Even if this occurred, "it probably wouldn't be dramatic, due to corporate outsourcing of labor and other factors," said Mr. Holland. Thus, he remains relatively sanguine about the markets. While still fully invested in stocks, he also has neutral durations on his bond portfolios. He expects the long bond to trade in a 6.5% to 7.25% range for the rest of the year, and stocks overall should head higher, with gains largely in smaller cap issues. (As of Jan. 1, Holland Capital had $372 million of U.S. institutional tax-exempt assets under management, 57% of which was in bonds.)
Harbor Capital Management, Boston, is also fully invested in stocks (with stocks, it is a large-cap manager); and with bonds, it shortened durations modestly a few months ago but "substantially has done nothing," said Chairman Frederick G.P. Thorne.
Harbor Capital expects some slowing of economic growth, which would come in this year's third and fourth quarters. As a result, no dramatic interest rate hikes will be needed. As Mr. Thorne put it, "while you may get a notch up in rates sometime this summer, they won't significantly increase over the next 12 months." Effectively, that maintains the "status quo from what we've been having over the last year," he said.
At the beginning of this year, Harbor Capital had $3.8 billion of U.S. institutional tax-exempt assets under management; of that, 67% was in stocks.