Talk of tighter monetary policy has been greeted with alarm by the market, but now some believe that a near-term increase in rates may not be such a bad thing after all.
Last week Federal Reserve Chairman Alan Greenspan sent a clear message to the market that economic growth and inflation are on the rise, and that interest rates will soon follow.
Greenspan surprised the financial markets with his uncharacteristically candid remarks about the direction of interest rates, something of a taboo for central bankers.
The Treasury market, as one might expect, showed its disapproval. Buyers turned into sellers. Retail investors ran for the hills. And long-term rates rose, casting a sense of uncertainty over one of the most impressive bond market rallies in history.
Market psychology turned a shade more bearish as participants came to grips with the possibility that long bond yields had stumbled on their extended march south.
But as the dust clears, some market observers are looking more favorably upon the prospects for higher short-term rates.
"Higher rates will clearly benefit the market," said Robert DiClemente, director of bond market research at Salomon Brothers. "If the Fed tightened under current economic conditions, where growth is slow, it will mean lower inflation."
Analysts believe that, after an initial lurch, the market will be helped by higher rates.
Like most observers, DiClemente believes that the first sign of tightening will spur a round of selling. But once the shock has been absorbed, investors will revel in the fact that the the Fed means business on inflation.
If investors believe the central bank means business on inflation, they will be more comfortable holding bonds and long-term interest rates will be lower, DiClemente said.
Higher short-term rates are also likely to usher in a new trend toward a flattening yield curve, which will improve market sentiment while refocusing interest on long-dated paper.
"In the long run the Fed is showing the investing public it wants to stay ahead of the inflationary curve," said William Sullivan. director of financial markets research at Dean Witter Reynolds Inc.
"Higher short-term rates will calm future inflation expectations considerably and possibly allow long-term rates to come lower," Sullivan said.
Brian Wesbury, chief economist at Griffin, Kubik, Stephens & Thompson, said the bond market has already begun factoring in a tightening of monetary policy. The prospect of higher rates and a flattening yield curve has directed a sizable amount of investor interest to the center of the yield curve, he said.
"It's clear the market is looking to buy the intermediate sector to cushion itself from risk and profit when the curve begins to flatten," he said.
Higher rates may result in stepped-up foreign demand for Treasury securities, analysts said. Higher U.S. interest rates and a stronger dollar will make dollar-denominated investments more attractive, particularly with volatility heating up in world currency markets this week.
That view was amply supported by events in foreign exchange trading yesterday, when turmoil in the European Exchange Rate Mechanism sent the dollar soaring and led to a flight out of Europe and into the Treasury market.
Currencies in the ERM have come under pressure and displayed an increasing amount of volatility in recent sessions as the 12 members of the European Community move toward economic convergence.
As part of the EC's plan for a single currency by the end of the decade, all currencies must trade within certain prescribed ranges of the German mark.
Gabriele Lamers, international economist at Deutsche Bank, said the failure of the German Bundesbank to lower its discount rate yesterday has tied the hands of many European countries that desperately need to cut rates.
"France, Spain, Denmark, and the Netherlands are unable to lower interest rates even though their respective economies remain mired in recession," Lamers said. "The German central bank has to cut their own rates first."
With U.S. rates on the rise, and those in Europe and Japan likely to move lower, Lamers said that Treasuries could gain considerable sponsorship from foreign investors looking to insulate themselves from uncertainty in the world currency markets.