When will interest rates peak out in the current cycle?
This tricky question has portfolio managers scratching their heads these days as they try to determine the best time to start redeploying their fixed income investments away from short-term instruments like Treasury bills and bank certificates of deposit and back into long-term bonds.
Correctly calling the turn in interest rates provides a double dividend: It not only allows you to lock funds in at a high yield for a long period, but also you find you underlying investment appreciates in value when interest rates actually turn tall and go down.
A bond that is purchased with a 10 percent yield, for example, is worth more than its face value when coupon rates for a comparable instrument fall back to 8 percent, just as an 8 percent bond drops in value when prevailing rates rise above that level.
But calling the precise peak in interest rates is one of the more difficult fears for financial analysts. And right now the outlook for economic growth, monetary policy and inflation seems to be so murky that some of Wall Street's most highly regarded analysts are coming out with very different scenarios.
Henry Kaufman, the Salomon Brothers partner who is also the firm's chief economist, believes that interest rates, while extremely high, have not yet begun to restrain the very heavy demand from all sectors of the economy for credit. Therefore, rates may challenge the historic highs reached in 1974, before they turn down.That top may not come for another 9 months, he says.
"I could see AAA utility bonds testing their high of 1974 of 10 1/8 percent," says Kaufman, which would put the rates a full percentage point above what they are today.
William Griggs, senior vice president and economist for the J. Henry Schroder Bank and Trust Co., believes that the economy is weakening rapidly and that inflation by the end of the year could be quite a bit lower than current rates.
He therefore predicts the peak in short-term rates could come by the beginning of November - "if anything sooner rather than later" - with long rates peaking not much after that. He also observes that the rates on high-quality bonds may not in fact move much higher than the 9 percent plus levels they are yielding currently.
"From the investment point of view, this scenario says that if you do start planning to begin extending maturities, you want to start doing it fairly quickly," says Griggs. "I wouldn't suggest you put ll the family jewels up right away. But don't wait until you see the whites of their eyes. You may not quite hit the top, and may not look good for a few months, but you will look very good a year from now."
The different outlooks arise from some very different assumptions.
Kaufman, who testified yesterday before the congressional Joint Economic Committee, thinks that consumers, businessmen and the financial markets themselves have adjusted to inflation and a higher prevailing level of interest rates since the last crunch in 1974, and have therefore not been deterred from continued heavy borrowing in spite of the historically high rates that are being quoted today.
"The cutting edge of monetary restraint, at least so far, is not clearly visible in the credit markets, even though interest rates have increased sharply since early 1977," Kaufman told the committee.
A Treasury auction of 15-year bonds yesterday went out at a yield of 8.63 percent, not far from the government's all-time high borrowing cost for a long-term bond of 8.72 percent which was hit in 1974.
"In the entire post World War II period, the average annual yields in long government bonds and mortgages have never been higher than current levels and utility yield average higher than they are presently," he said, but added "I know of no creditworthy borrowers that are shocked by the prevailing structure of interest rates, which not too many years ago, would have been viewed with consternation.
In fact, home mortgage rates of more than 10 percent are not deterring people from buying homes because they think the value of their purchase will appreciate faster than inflation, making it still worthwhile at these higher rates, he observed.
The torrid demand for credit, the continued rapid rate of growth in the money supply, and a cost-push inflation resulting from a tightening skilled labor market all add up to rising inflation and much higher interest rates, in Kaufman's estimation. He thinks that the federal funds rate, which is a kind of bottom benchmark, and is currently at 7 3/4 percent, "could be at 8 1/2 to 9 percent by year-end."
Griggs, on the other hand, thinks that the peak in federal funds will probably be 8 percent, with the next tightening move by the Federal Reserve Board, probably in late July, the last for the year.
"The Fed won't turn on a dime and go the other way instantly, but it is not out of the question to actually see the Fed easing before the end of the year," says Griggs.
"With substantial weakening in the economy already evident, and inflation probably going to be looking better in coming months, it is irrational to expect continued firming from the Fed," he says.
Long-term rates, however, could still continue to go up even after short-term rates peak, because of a heavy corporate and government borrowing calendar anticipated for the second half of 1978, particularly the last quarter, which becomes an independent force for pushing up interest rates.
But he doesn't see long-term rates surging, and he observes that the rates on high-grade bonds, which peaked three months after federal funds did in 1974, fell back rapidly as soon as the turn came.
"When the turn comes, rates run away from you very quickly on the downside," he notes.