NEW YORK (CNNfn) - The looming shadow of higher interest rates ahead has spread chills throughout U.S. financial markets in recent weeks, even though most economists say official rates won't be increasing in the immediate future.
Long-term interest rates, mirrored in 30-year Treasury bond yields, have climbed nearly 60 basis points so far in 1998, while a parade of indicators shows the U.S. economy growing at a boisterous rate despite continued weakness overseas.
Together, the two factors point toward a revival of inflationary forces long thought dormant in the economy, forces that many investors now fear could provoke the Federal Open Market Committee to adopt a bias toward higher interest rates.
"I view the risk as very high that the Fed shifts its bias to tighten (interest rates) sooner than we had forecast," said Diane Swonk, deputy chief economist at Banc One Investments. "The risk is rising that they will move sooner."
Not now, soon
That said, few expect the Fed to raise rates when it next meets on March 30 because inflation remains a relatively mild threat so far.
"I think they're going to remain on the sidelines until we see some evidence of inflation," said John Woolway, portfolio manager at First Omaha Funds.
Likewise, Larry Chimerine, chief economist at the Economic Strategy Institute, sees low inflation - specifically price inflation -- as the primary factor staying the Fed's hand.
"I don't see how the Fed can tighten as long as inflation is as low as it is," he said. "It should be obvious to everyone now that there's been a major change in the inflation process in this country. Every industry is experiencing intense competition. Nobody can raise prices. There is no pricing power in any industry any more as long as those conditions continue."
One stumbling block could be wage inflation, which both bond traders and the Fed are watching carefully for signs of unmanageable growth.
Economists predict that when the Labor Department releases February payroll data Friday, the job market will remain tight, increasing by 245,000 jobs, while hourly earnings slow their rate of increase to 0.3 percent from January's 0.5 percent figure.
If the numbers exceed the forecasts, bond yields are likely to rise again, boosting long-term rates.
Bonds doing the job
In the absence of significant inflation, Chimerine and other economists see the bond market as doing the Fed's work, rendering a full-fledged rate hike unnecessary for now.
Kim Schoenholtz, chief economist at Salomon Smith Barney, said that "long-term interest rates are serving as a kind of thermostat for the economy."
"They're telling you that it's going very fast and they're playing a role much like what the Fed used to do in the past of sending a signal about how strong growth really is," he said.
As an example of how soaring long-term rates have already slowed certain elements of the economy, Chimerine of the Economic Strategy Institute pointed toward slowing sales of new homes and a decline in mortgage refinancing.
Furthermore, he noted that evidence of easing growth pressures will eventually encourage investors to pick up bonds again, driving long-term rates back down.
"It will slow the economy enough so that as long as the Fed doesn't tighten . . . we'll start to see long-term interest rates move back down," he said. "But for the moment, until the market sees some signs that growth is slowing, they'll probably stay at this level or maybe move slightly higher."
No matter how closely the bond market unofficially regulates the economy, the experts are less sanguine about the longer-term prospects of the Fed holding still.
"Fighting against rising interest rates just seems a waste of time," said Robert DiClemente, co-chief U.S. economist at Salomon Smith Barney. "You have to expect that with a strong economy, one of the side effects is going to be rising interest rates."
Henry Willmore, senior economist at Barclays Capital, agrees the Fed could act decisively in coming months.
"We say there's a 40 percent chance of a tightening in the second half of the year, much higher than I would have said just a few weeks ago," he said.
Tiptoeing around the edge
Meanwhile, soaring bond yields not only push mortgage rates higher, but risk triggering a flight from the U.S. stock market as well.
"I assume there's negative news to come," said Salomon Smith Barney's Schoenholtz. "Higher yields will reveal the vulnerability in U.S. equities, which are richly valued."
Since Alan Greenspan opened the box of rate fears with his Humphrey-Hawkins testimony last week, the threat of a Fed move has combined with other factors to pummel confidence in both bonds and stocks.
The Dow industrials have fallen nearly 3 percent, 276.8 points, since then, while the broader market as reflected in the S&P 500 has tumbled an even deeper 3.5 percent or 44.44 points.
Bond yields, meanwhile, have climbed 34 basis points during that same period, accounting for more than half their rise this year.
David Horner, senior financial strategist at Merrill Lynch, said that the stock market can ignore rising bond yields for a long time, but the 1987 crash demonstrated that such ignorance might not be bliss.
"In 1987 the bond yields went up for 10 months . . . until the stock market finally reacted," he said. "And of course when it reacted, it really reacted. I'm not looking for anything like that. What I am suggesting is that rates can go up without the stock market taking much notice, but there does exist some breaking point."
Where it stops
For Horner, that "breaking point" could come when the long bond yield creeps above 5.75 percent, at which time the stock market risks being "set back a little bit more."
That 5.75 percent benchmark is the figure to watch for other analysts as well.
"I do think interest rates are going to go a little bit higher on a very short-term basis. One a pure chart read of the yield of the 30-year bond itself, 5.75 percent is a legitimate target to the upside," said Greg Nie, sector analyst at Everen Securities, adding that he would be "a little surprised if we got higher than 6 percent."
-- by staff writer Robert Scott Martin