Commentary: The Fed Can't Afford a Bond Market without Faith

By Rich Miller

What we have here is a failure to communicate. The bond market has been on a roller-coaster ride recently as investors struggled to divine the intentions of the Federal Reserve. Gambling that the Fed would buy bonds to help ward off deflation, investors piled into the market in mid-June, sending the yield on the 10-year Treasury note to a 45-year low of 3.1%. But when the Fed opted to merely trim interest rates on June 25, investors turned tail and sold.

The coup de grâce came on July 15 as Chairman Alan Greenspan forecast faster economic growth and seemingly all but ruled out bond purchases by the Fed. The market quickly tanked. Greenspan tried to turn the tide the next day by saying he hadn't taken bond buys off the table. The damage had been done, though, and the 10-year yield ended the day at close to 4%.

The wild market fluctuations have left a sour taste in the mouth of many a market participant. Some mutter about being manipulated and misled by the Fed. "Greenspan has lost some credibility with the market," says Melvyn B. Krauss, senior fellow at Stanford University's Hoover Institution.

Of course, some of the rise in bond yields is due to growing hopes for an economic rebound -- a phenomenon to be welcomed. Yet the rapid increase in long-term interest rates also reflects wariness about the Fed, and that's far more worrisome. If investors feel they can't count on a predictable Fed, they're apt to push bond yields and long-term rates up higher than justified by the strengthening economy alone. A premium for Fed risk could even lift rates to the point where they hurt the very economic recovery the market is anticipating. "This is not an economy that's going to take off like a rocket," says former Fed Governor Lyle Gramley, now senior economic adviser for Schwab Capital Markets LP. "I would be more comfortable if 10-year yields were at 3 1/2%, instead of 4%."

Such a reversal isn't likely anytime soon. The federal budget deficit is ballooning. The White House on July 15 predicted a financing shortfall of $455 billion in fiscal 2003, and $475 billion for fiscal 2004. The forecast fanned fears in the bond market of stepped-up sales of Treasury securities, helping to send prices even lower.

What's more, dealers, banks, and hedge funds are sitting on large bond positions they built up via so-called carry trades -- borrowing money at low short-term rates and then investing it in longer-dated securities. But with the value of those bond investments falling, there's a risk of a major sell-off as those trades are unwound, says economist Henry Kaufman.

Who's to blame for the breakdown in communication, bond traders or the Fed? The answer: a bit of both. Fed policymakers egged on investors in June with warnings about the dangers of falling prices, capped off by Greenspan's colorful comments on the need to build a "firebreak" against deflation. In private meetings and public speeches, Fed officials suggested they were deliberately trying to guide long-term rates lower and left open the possibility of buying bonds to help their chances. "I don't think the market was completely on drugs," says Citigroup economist Robert V. DiClemente.

There's no doubt that investors read more into some comments than the Fed intended. They ignored repeated warnings by Greenspan and other Fed policymakers that the risk of deflation was, after all, remote. Instead, they snapped up bonds in the mistaken belief that a desperate Fed would bail them out by buying up their securities. "The market has got to take some responsibility for its own actions," says former Fed Governor Laurence H. Meyer.

Whoever is at fault, the markets' eroding confidence in the Fed has consequences. The danger grows if investors feel so threatened by what they see as an unsteady Fed policy that they demand ever higher risk premiums on Treasury bonds. It hasn't happened yet. If Greenspan & Co. aren't careful, however, they could be in for another month like the last -- and the economy will be the loser.

Miller covers the Fed in Washington.

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