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The Fed Can't Get Ahead of the Curve

By Michael Wallace Following a series of body blows to the U.S. economy since its last interest rate cut on Oct. 2, the Federal Reserve stands ready to ease yet again. Standard & Poor's MMS expects the Fed to put its best foot forward with another half-point cut on Nov. 6, which would bring the federal funds target rate (what banks charge for overnight loans) to 2%. The funds rate is at its lowest point since May, 1962, and a half-point cut would trun back the clock even further, to September, 1961.

The latest economic data -- including an 8.5% plunge in durable-goods orders in September, a precipitous 11-point decline in consumer confidence in October, and a sharp fall in the National Association of Purchasing Managers' index to near-historic lows in October -- have given Fed Chairman Alan Greenspan & Co. no relief in their struggle to get ahead of the curve. The Treasury yield curve, that is, which represents the interest rate spread between the shortest- and longest-maturing debt issues.

STEADY PATH. Since the start of 2001, the Fed has eased the funds rate from 6.5% to 2.5%. If it cuts the expected 50 basis points on Nov. 6, that would bring the total reduction to 450 basis points, the most aggressive easing campaign in decades. Yet yields on the two-year Treasury note have moved in lockstep with, if not persistently ahead of, the Fed for most of this year. That can take away the Fed's ability to maneuver. If market rates get too far ahead of the Fed's target, especially at times like this when an end to easing may be near, that could create turmoil in the bond market.

Two-year yields have beaten a steady downward path, culminating with a move from around 3.5% to 2.8% after the dislocating events of September 11. This preceded the Fed's back-to-back half-point cuts -- the first, an intermeeting reduction on Sept. 17 to 3%, followed by a second, announced at the scheduled Oct. 2 policy meeting, to 2.5% -- which briefly put the Fed ahead in its footrace with the Treasury yield curve.

In the wake of the latest plunge in consumer confidence and in reaction to the war on terrorism, two-year yields have begun to nose lower than the 2.5% Fed funds target rate -- a key intersection. This marks the lowest yield for the two-year note since its introduction in 1972.

LEAPFROG. Prior to the 1990-91 recession, a sharp drop in two-year yields in April, 1989, from around 10% to near 7%, signaled similar adjustments by the Fed. It wasn't until early 1991, however, that the Fed finally got ahead of the curve, when it moved the Fed funds target to just below 8%.

Back then, the Fed stayed ahead of two-year yields all the way down to the low point of 3% reached on Sept. 4, 1992, a level the Fed held until Feb. 4, 1994. And the Fed funds rate remained below that of two-year yields until April, 1995.

Where do things stand now? Fed funds futures now price in about a 60% chance that the Fed will leapfrog the market with a half-point cut. An historical study of spreads would suggest that the Fed will have to get ahead -- and stay ahead -- of the curve for a sustained period with negative real interest rates (which occur when nominal interest rates are actually lower than the rate of inflation) to ensure economic recovery. And so the risk seems high that nominal rates will be coming down until at least the second half of next year.

ONE BOLD STROKE. The surprising cessation of 30-year bond issuance by the Treasury this week has put an additional burden on the short end of the curve. To a greater extent, a slight subsequent move higher in two-year yields was due to the dramatic unwinding of curve-steepening trades -- market bets that short-term rates will fall while long-term rates climb -- that dominated prior to that event. But it also reflects some unease about funding a rising and potentially persistent fiscal deficit by issuing shorter-term notes.

One remarkable aspect of Treasury's move was that it virtually usurped monetary policy and achieved in 24 hours what the Fed was unable to do in 10 months: drive bond yields more than half a percentage point lower. That drop represents a sizable stimulus to the economy, and some market participants have expressed concern it could cause the Fed to temper its easing hand as early as the Nov. 6 policy meeting.

Moreover, recent warnings to Congress from Treasury Secretary Paul O'Neill and Greenspan that an ill-conceived and oversize economic-stimulus package could drive yields higher suggest the top levels of U.S. economic management were involved in the timing of the decision to cease issuing the long bond. Still, even if the line between fiscal and monetary policy has been blurred, the Fed has work to do, and it may still be some time before the market sees signs of a recovery.

CLINCHING THE DEAL. The weak numbers in the October employment report released Nov. 2 are likely to harden the Fed's resolve to ease. And other developments on the horizon may clinch the deal: a reverse wealth effect, whereby declining asset values cause consumers to shut their wallets; a weakening housing market; ongoing domestic terrorism threats; and rising unemployment.

A synchronized slump in business and consumer spending will add more pressure. There will be boosts from government spending on defense and public-health infrastructure as well as from tax cuts and stimulus, but these will take time to kick in.

And so the Fed will continue to scramble to stay ahead of the curve. But a bottom in the economy will become apparent only when yields on the two-year note stop their downward march -- and the Fed is finally able to have its way. Wallace is chief market strategist for Standard & Poor's Global Markets

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