Rate Hike May Be Unlikely, But Investors Not Taking Chances

A Federal Reserve interest rate hike in the coming months is being viewed with caution by analysts who say the economy is nowhere near ready for policy makers to put the brakes on growth.

While the chances of a rate hike were nearly unthinkable just a few weeks ago, a change in perception has come in the past few days as a few key metrics have caught the market off guard.

The Federal Reserve headquarters in Washington, DC.

Many doubt the Fed will actually raise rates before the end of the year or even early next year, but market behavior lately has indicated growing unease that money-tightening could be around the corner.

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Rising rates are feared by those who believe they will stymie the housing market and thus broader economic health.

Yet not everyone is afraid. Some say a rise in rates actually could be a positive in that it would restore confidence that policy makers are moving away from fear and towards getting the markets back to normal. Solid balance-sheet companies not dependent on leverage would do best in that case, while multinationals and financials would get hit, experts say.

The latest government nonfarms payroll numbers showed the economy shed 345,000 jobs—far fewer than expected and indicative that perhaps the economy was improving faster than experts had thought. At the same time, investors have been watching as yields have surged on two-year Treasurys, representing the short end of the curve, often a precursor to Fed hikes because the market will generally try to price in such moves ahead of time.

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That has sent stocks sideways in the past three trading days amid fears that a Fed hike would boost mortgage rates, which have risen about a full percentage point the past month.

"We think the odds of tightening this year are very low, but the market saw last month's unemployment reports as a real game-changer," says Zach Pandl, an economist at Nomura Global Economics. "It went from pricing in no Fed action this year to pricing at least one, possibly two rate hikes by the end of the year. We and most forecasters saw that as a pretty surprising development."

Indeed, fed fund futures trading have shown a strong inclination that the central bank will hike rates, by as much as three-quarters of a point by the January meeting.

Traders backed off that sentiment somewhat on Tuesday, with the year-end target moving to 0.44 percent by the end of the year, down from 0.505 percent Monday, and to 0.76 percent off the January meeting, which is down from 0.86 percent Monday. The current Fed target rate is zero to 0.25 percent, following an aggressive series of cuts aimed at increasing lending and boosting bank balance sheets.

"If the Fed is likely to tighten it could mean that growth outlook, profit outlook has gotten a little bit better," Pandl says. "At the same time, a higher discount rate is going to lower the fundamental value of equities as an investment. The equity market seems to be struggling with balancing those two aspects right now."

Many analysts believe the Fed is highly unlikely to boost rates until unemployment turns around, despite what Friday's payroll numbers suggest.

"The norm is not for the Federal Reserve to begin raising rates while unemployment is still an issue," says Quincy Krosby, chief investment strategist for The Hartford. "The Federal Reserve is going to watch the consumer's behavior and the ability of the consumer to get jobs before they begin the upward path of removing liquidity. I think it is premature for the market to obsess about the Fed."

The economy also is suffering through a period of decreasing capacity utilization, and few other signals have shown an actual improvement in conditions, only a lessening in deterioration.

"In that sort of environment there is no fundamental case for tightening credit," Jan Hatzius, chief economist at Goldman Sachs, said on CNBC.

Getting Back to Normal

To be sure, a rise in rates is not universally dreaded.

Moving interest rates back to pre-credit crisis levels, in fact, would more closely represent where the market should be and thus provide confidence that things are going back to normal, says Tom Sowanick, chief investment strategist at Clearbrook Investment Consulting in Stamford, Conn.

"Everybody's fearful the Fed is going to tighten," he says. "The terminology is wrong. It's 'normalize.' "

Investors will be watching Fed Chairman Ben Bernanke for the central bank's direction, but Sowanick believes the central bank will provide sufficient warning that investors will act accordingly ahead of time.

"Bernanke has been pretty clear that we need to put discipline back into the system," Sowanick says. "When he says that he's not just leaving it at fiscal discipline, I think there's monetary discipline that he's also referring to."

Under the mentality, companies with strong capital positions and low leverage could be expected to perform best. Sowanick identifies those sectors as materials, technology and industrials.

Still, others feel policy officials have alternatives in their tool kit to stem any inflationary concerns that arise, such as stopping the purchase of Treasurys while continuing to buy mortgage-backed securities.

"You still have an economy where confidence in terms of employment is not back," Krosby says. "I think the Fed is going to realize that the stage is not being set for job creation. To the contrary, in the private sector the stage is being set for business owners to be very cautious."

Yet the idea persists in the markets that the Fed might make a move, and that in itself could cause market gyrations.

"Even the perception of rate hikes matters for the equity markets." Nomura's Pandl says. "To the extent that higher expectations for the fed funds rate translates into higher corporate bond yields, higher Libor, higher mortgage rates--that's a negative for the economy."

© 2009 CNBC.com