Ghosts of 1994: Gone but Not Exorcised

Looking at the bond market, Gross said the 10-year note yield reflects the expectation that the Fed will halt its rate-hike campaign even sooner, stopping with the fed funds rates at 2.5% or less.

In Gross' shop, they've been expecting that the Fed's tardiness in raising rates has set the stage for an upswing in inflation, the real destroyer of bond value. While Fed officials and other economists have played down the significance of sky-high oil prices, Pimco managers see crude's rise as a sign of just how much stimulation has been pumped into the economy.

"The reality has to acknowledge the fact that oil may be as much of a symptom as a cause of inflation," John Brynjolfsson, another Pimco fund manager, wrote this week.

The Fed's low rates have helped the markets weather the end of the Internet bubble, he wrote, "but it is that liquidity which fuels world aggregate demand to the point where oil demand is getting ahead of supply and the same dynamic affects other areas; healthcare, housing and the economy more generally."

The weak dollar also feeds inflation by raising the cost of imported goods. The dollar hit an all-time low vs. the euro this week and was near decade lows against other major currencies. A Commerce Department report on Wednesday found the price of imported goods had risen 12% over the past year and almost 3% excluding oil. And the Fed can address the dollar's weakness only by raising rates. Indeed, the dollar stiffened a bit against the euro on Wednesday after the hike.

So the Fed has but one way to go, and that could be a painful march for the complacent.

While the ramifications are most acute for fixed-income investors, a report by Prudential Equity Group found financial institutions such as Citigroup (C Quote), Bank of America (BAC Quote) and Fifth Third Bancorp (FITB Quote) have yet to rearrange their balance sheets in anticipation of higher rates. Homebuilders are also still loading up on debt to buy land in anticipation that real estate will stay hot, even as the refinancing boom wanes and still higher rates threaten to curtail future housing activity.