There is an old saying on Wall Street: Don't fight the Fed. Nevertheless, the bond market seems intent on doing just that. In one corner, key bond players believe that the economy is slowing, that inflation is not a threat, and that the Federal Reserve's work on raising short-term interest rates is about finished. In the other corner, Fed policymakers appear to favor a more aggressive approach to lifting rates in order to contain inflation and find it puzzling that the bond market -- and long-term rates -- are resisting the Fed's lead.
By historical standards, the response of bond yields to the Fed's 2 percentage-point hike in the federal funds rate since last June is highly unusual. At this point in the Fed's policy tightenings that began in 1994 and in 1999, the yield on the 10-year Treasury bond was up by about two percentage points and one percentage point, respectively, above where it was when the Fed began to lift short-term rates. But now the 10-year yield is a half-point below where it was last June. Based on past trends, the 10-year yield should be in the 5% to 6% range, instead of barely 4%.
Market rates that low are at cross-purposes with the Fed's goals. As was made clear in the just-released minutes of the Fed's May 3 meeting, policymakers are lifting short rates from levels that are still too stimulative to growth and inflation. However, credit remains freely available in the financial markets, and banks are dramatically easing their lending standards to their corporate customers to compete for business. Mortgage rates are still exceptionally cheap, sending April home sales soaring and causing Fed Chairman Alan Greenspan to admit recently that there is "froth" in some local housing markets. At the same time, the trend in inflation outside of energy continues to drift upward, and hourly wage growth continues to pick up as the labor markets tighten.
Strangely, none of this seems to worry the bond market. In particular, bond folk point to the flattening of the yield curve as a traditional sign that the economy is slowing down. That is, when short-term interest rates begin to approach or even exceed long-term rates, it usually has been a signal that Fed rate hiking has been sufficient to chill the economy and its inflation potential, and that further hikes may be inappropriate.
MAKE NO MISTAKE, this is a heavyweight battle, and the outcome could have crucial implications for the economy. If the Fed is wrong, it could end up overtightening policy, possibly damaging the economy in 2006. If the bond market is wrong, history shows that market sentiment tends to turn on a dime, and a sudden lurch upward in yields could create stresses on credit availability, stocks, and the dollar. Financial volatility could ripple more broadly through the U.S. and world economies. Some hedge funds may be particularly vulnerable to a big and sudden market shift.
By a large measure but certainly not in total, the path of the economy in coming months will decide the debate. And so far, it looks as if the Fed has the upper hand. Economic growth in the first half of 2005 is turning out to be a lot stronger than it appeared only a month or two ago. Many economists now believe that first-half growth will show little slowdown from the 3.9% annual pace in the second half of 2004. Healthy job growth has helped get consumers over the energy hump, suggesting another solid contribution to second-quarter growth from household spending. And businesses remain confident in the future, based on the rising trend in orders for capital equipment. Orders for capital goods excluding defense and aircraft rebounded 1.6% in April, implying no letup in capital spending.
CONTRARY TO THE FED'S INTENTIONS, much of this strength is the result of the current low yields in the bond market. Take demand for housing. April existing home sales rose 4.5% to hit a record annual rate of 7.2 million. New home sales for the month edged up to a record pace of 1.32 million. Surely to the surprise of policymakers, mortgage rates are lower now than they were last summer. According to Freddie Mac (FNM ), the rate on a 30-year fixed mortgage averaged 5.86% in April, compared with 6.29% last June. Higher, too, is the easy availability of bank loans, enabling businesses to build up their inventories cheaply and expand their operations, another contributor of growth in the first half.
Unlike the bond market, which is often more impressed by the monthly squiggles in the data, the Fed appears to be taking a longer view of the economy's inflation potential. For example, in the minutes of the Fed's May 3 meeting, released on May 24, all policymakers "judged that the current level of short-term rates remained too low to be consistent with sustainable growth and stable prices in the long run."
Moreover, some policymakers suggested that, to the extent higher energy prices were permanent, the economy's long-run, noninflationary growth rate might be a shade lower. That would mean, with an economy growing close to 4%, pricing pressures may be greater than they would be otherwise. Indeed, the Fed noted that, since companies have been successful in passing along their higher costs, competitive pressures and slack resources may not be restraining inflation as expected.
IT IS ALSO IMPORTANT to bear in mind that the credit markets are increasingly global. So the flattening of the yield curve may not be signaling a U.S. slowdown at all. One of the reasons bond yields are so low is because foreign demand for U.S. Treasuries is strong, which pushes their prices up and yields down.
Why are U.S. securities so popular? First, with the rest of the world awash with savings, the yields in the U.S. are very attractive, especially relative to those in the euro zone, where 10-year yields are generally below 3.5%. Second, growth prospects for the U.S. are strong. In its semiannual Economic Outlook, the Organization for Economic Cooperation & Development revised downward its growth forecasts for both the euro zone and Japan, to 1.2% and 1.5%, respectively. The OECD expects the U.S. to grow 3.6%, in line with most other forecasts.
Finally, China and other Asian nations continue to recycle their foreign currency reserves -- the result of their huge trade surpluses with the U.S. -- into purchases of U.S. Treasuries. These actions have little to do with inflation expectations, the typical primary driver of bond yields. Instead, these emerging nations are trying to protect their currencies in order to boost demand for their exports.
The increasing U.S. dependence on foreigners to fund its borrowing highlights another danger in the square-off between the bond market and the Fed. Both bond traders and policymakers must pay heed to global actions to a greater degree than was the case back in the tightening cycles of the 1990s. The longer the clash continues between bond market sentiment and Fed goals, the greater the risk that some unforeseen development, whether the collapse of an overextended hedge fund or a spike in a foreign currency, could provide the sucker punch that fells the best intentions laid out by the markets and the Fed.
By James C. Cooper & Kathleen Madigan