Strategists split on rate rise fallout

Phones hang from a trading terminal on the floor of the New York Stock Exchange, in this May 19, 2009 file photo.

NEW YORK (Reuters) - The recent rise in U.S. interest rates is causing a split among Wall Street's top strategists on the implications for inflation and the economy, contributing to one of the trickiest investment environments in recent memory.

The jump in yields on U.S. government debt, which act as a benchmark for many lending rates, particularly mortgages, also drew sharply differ views at the Reuters Investment Summit Outlook in New York on the extent to which they could contribute to another leg down in housing prices.

The collapse of the housing market was a key factor in driving the economy into recession, and its recovery is seen equally key to the economy's return to growth. Lower housing prices have contributed to high foreclosure rates, with cash-strapped borrowers unable to sell at prices that allow them to pay off their mortgages.

Abby Joseph Cohen, senior investment strategist at Goldman Sachs, said the rising interest rates showed that investors are becoming less risk averse as worst-case scenarios for financial markets and the economy have not played out.

"As we move back to normal, money would naturally come out of Treasuries and into other assets," she said, adding that part of the move is "a vote of confidence in the economic future."

By contrast, fears of high inflation are "spectacularly premature," Cohen said. "We just don't see that inflation is going to rear its ugly head."

She cited low capacity utilization of U.S. businesses, a high jobless rate and stagnant wages -- a major cost of business -- as evidence that inflation is not a worry.

Several Federal Reserve officials have recently talked at length about the threat of inflation. They say the U.S. central bank needs to start reversing monetary policies undertaken to loosen crippled credit markets, including rock-bottom interest rates, as soon as feasible.

The benchmark 10-year Treasury note yield briefly traded above 4 percent last week, up from about 3.08 percent in mid-May -- a sudden sharp increase that quickly caused mortgage rates to rise and mortgage activity to decline.

"There is a fundamental mismatch between available credit and available buyers. Not enough people can afford loans to absorb housing at its current prices," said Sean Dobson, chief executive officer Amherst Holdings LLC.

The recent, sudden jump in mortgage interest rates was something the Fed and the White House did not anticipate, and has become a problem for efforts to rework many existing mortgages at lower rates, said Greg Peters, Morgan Stanley's head of global fixed-income and economic research.

"We think housing has considerable downside from here," perhaps to the tune of another 16 percent decline in the national Case-Shiller index by early 2010, Peters said.

Although Peters said he is not worried about inflation, he said rising inflation concerns by investors is an issue.

"I don't think the Fed is as worried about inflation as the markets are," he said.

"Am I worried about inflation today? No. But the markets are clearly starting to worry about it, and that's more important. ... The yield curve is not steepening because of growth expectations; otherwise the dollar would not be weakening."

Peters said the 10-year Treasury yield could hit 4.75 percent this year.

The issue of inflation comes up as one of the most important for investors, particularly with the Fed's near zero-rate policy and various liquidity programs, Peters said.

The Fed already has greatly increased one measure of the nation's money supply. The monetary base has doubled since August 2008, according to data from the St. Louis Fed.

Peters said the Fed could show vigilance against inflation with a single, 25 basis point increase in its benchmark federal funds rate, something the market consensus suggests is unlikely for the rest of 2009.

Still, he said, "astute investors" were not lining up on either side of the inflation issue, illustrative of the uncertainty surrounding the economy.

"You get a room of investors together and they are split between inflation and deflation ," Peters said.

(Additional reporting by Jennifer Ablan; Editing by Leslie Adler)