Commentary: The Bond Market May Lead The Next Rate Rise

Expect less focus on the Fed and more on the economy

The way some folks in the financial markets talk, you'd think the Federal Reserve was the only game in town when it comes to setting interest rates. Just keep a close watch on the Fed and you'll know where rates are headed, or so the market chatter would seem to imply.

Well, it's not quite that simple. Sure, Fed Chairman Alan Greenspan and his colleagues control short-term interest rates via monetary policy. But when it comes to determining long-term rates in the bond market and elsewhere, their influence is much less direct. Ultimately, it's bond investors' independent judgment of where the economy is headed -- and the implications of that for Fed policy -- that determines long rates. That may seem obvious, but it's a point well worth remembering as pundits debate whether the Fed will feel constrained from raising rates as the Presidential election approaches.

Indeed, if bond yields do rise in coming months in reaction to faster economic growth and falling unemployment, that would make it easier for the Fed to increase short-term rates without triggering a big political backlash. "It would give them cover," says David Gilmore of consultant Foreign Exchange Analytics.

Fed research suggests that the bond market has gotten a lot better in anticipating the central bank's actions in the Greenspan era. Before he took the helm in 1987, longer-term rates usually moved in lockstep with changes in short-term rates by the Fed. Since then, as the Fed has become more open about monetary policy, market rates have tended to move several months ahead of the central bank. That was certainly the case in 1999 and into the 2000 Presidential election year, when the Fed last tightened credit. Indeed, in what might be a harbinger of what happens this year, Greenspan cited rising bond yields back then as one reason for the Fed's repeated rate hikes.

To be sure, the financial markets were caught by surprise when the Fed started raising rates in February, 1994, as the economy recovered from recession. Bond prices tanked, and investors, including California's Orange County, lost billions of dollars. But this time, at least judging by surveys of institutional investors, the market seems much better prepared, with many expecting higher rates in 2004.

The relationship between the Fed and the bond market is symbiotic. Each influences the other. Investors are trying to figure out where the economy is headed and how the Fed will respond. And central-bank policymakers are trying to determine what the market is saying about the economy and the soundness of Federal Reserve policy. "They're always asking themselves: 'Do the markets know something we don't, are they worried about our anti-inflation resolve?"' says former Fed Governor Janet L. Yellen.

BACK TO NORMAL. Sure, there were times last year when the bond market seemed to ignore the economic numbers and become obsessed by what Greenspan&Co. were up to. Yields fell to 45-year lows in June as investors bet -- mistakenly, it turned out -- that the Fed would buy bonds in the marketplace. Then, as the year ended, they became preoccupied with the Fed's pledge to keep short-term rates low "for a considerable period."

But those were unusual circumstances, reflecting the Fed's own concern about the risk of a deflationary downturn. Now that the economy has finally gotten up a head of steam, it's time for things to get back to normal -- for people to start focusing on the fundamentals again. That's what the Fed seemed to be saying on Jan. 28 when it backed away from its pledge of continued easy money. The central bank's message to the market, says Royal Bank of Scotland chief economist Ram Bhagavatula: "Don't obsess over the Fed. Watch the economic data."

Whether interest rates will rise this year is still anybody's guess. But if they do, don't be surprised if the markets, not the Fed, lead the move upward.

By Rich Miller

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