The Fed's Long-Term Headache

Despite repeated cuts in short-term rates, Treasury's benchmark 10-year has stayed stubbornly high

By Rick MacDonald

As the Federal Reserve's policy-setting arm, the Federal Open Market Committee readies to meet on June 25-26, expectations of interest rate hikes continue to subside. The recent weakness in the stock market, less positive readings in recent economic reports, strength in productivity, and the benign trends in inflation all make a strong argument for the Fed remaining on hold through yearend. And we at Standard & Poor's MMS agree with that view.

Clearly, yields on short-term Treasury issues -- hovering near their lowest levels in four decades -- reflect this increasingly subdued outlook. But yields on longer-dated issues have remained stubbornly high on a relative basis. Overall, this performance in the long end of the Treasury yield curve has limited the Fed's ability to get the economy running on all cylinders again.


  Looking at the current Fed funds rate, it's clear that current monetary policy has been very aggressive in using rate cuts to stimulate economic growth. The Fed funds rate sits at a 41-year low of 1.75%. Not surprisingly, the 1-year Treasury bill -- which is heavily influenced by Fed policy -- is hovering near the 44-year low of 1.93% that it hit in November.

While the 1-year bill is approaching a 40-year low, the 10-year note -- the benchmark Treasury issue -- is still trading more than 50 basis points above its November low. Moreover, there has been little net change since the beginning of the recession, in March, 2001. This has kept the spread between the 10-year and 1-year notes at around 270 basis points for the last seven months.

This is an unusually wide level, as it represents a spread that's nearly 100 basis points greater than the the average peak seen after the past nine recessions. In fact, the only post-recessionary period to see spreads peak at a wider margin was following the 1990-91 downturn, when the monthly spread averaged as much as 305 basis points. In our view, this seems at odds with growing expectations that this recovery will be modest by comparison, since wide spreads typically suggest that economic conditions improve at a faster pace.


  One of the more striking features about the early 1990s was the lackluster recovery that immediately followed the "official" end of the recession in mid-1991. Back then, yields on the long end of the curve remained stubbornly high during the recession -- as they do now -- and those high yields may have been one reason the initial recovery was less than robust. The 10-year yield dropped only a little more than half a percentage point during the 1990-91 slump, while the Fed eased nearly 200 basis points.

This highlights one of the Fed's weaknesses. While it effectively controls very short-term interest rates, Alan Greenspan & Co. has much less control over the longer-term rates that are so important in driving the economy. As such, the Fed's initial attempts to buttress the economy during the 1990-91 recession were, in a sense, "pushing on a string" -- it got very little economic bang for its easing buck. As a result, policymakers had to drop the Fed funds rate an additional three percentage points over the subsequent two years until long-term rates finally got down to a level that could help foster economic growth.

Interestingly, between the economic peak in March, 2001, through now, we have seen even less of a downward move in the yield on the 10-year note, which is around 4.8%. It has fallen only about 10 basis points during a time when the Fed has trimmed 375 basis points from the Fed funds rate, which came after cuts totaling 100 basis points in January, 2001. And unlike the 1990-91 recession, the Fed has little ammunition left, given the already low 1.75% Fed funds rate target now in effect.


  Some hope remains for the rate-setters. Overall, the sharp drop in yields in the June 19 Treasury session may finally mark the start of the drop in long-term yields that's needed to get the economy back up and running. The key question is not whether long-term yields need to come down, but to what level.

Because of the favorable inflationary and productivity backdrop, we think that the more likely way to close the wide gap will be a drop in long-term rates, rather than the Fed raising short-term rates. If long-term rates come down as we expect, the yield on the 10-year note could dip to 4%. If this happens, corporate purchasing managers -- and refinance-happy consumers -- just might rise to the Fed's bait.

MacDonald is a senior economist for Standard & Poor's/MMS International

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