In Greenspan Conundrum Redux, Odds Are on Bond Traders’ Side

The Federal Reserve faces another bond-market conundrum as it prepares to raise interest rates.

Policy makers including New York Fed President William C. Dudley are suggesting there’s something wrong with debt yields that aren’t climbing as the economy recovers. Yet traders are signaling there’s little reason long-term Treasury yields can’t, and won’t, stay depressed.

History is on the market’s side. The spread between yields on 10-year Treasuries and the Fed’s overnight rate is right where it should be based on past norms. And, in the last four decades, it’s been unusual for investors to demand more compensation to own longer-dated debt when the central bank increases its key rate.

Perhaps the bond market’s most important message is that the Fed’s own forecast for how much benchmark rates will rise is still too high, even after central bankers lowered their estimates last month. The market is calling for 2 percent rates in 2018, almost half what the Fed sees.

The Fed has “been wrong for so long,” said Jeffrey Gundlach, founder of Los Angeles-based DoubleLine Capital, which oversees $73 billion in assets. “Their incremental input in what will happen in the future has been literally of no value, because the market’s pricing has been closer.”

The dilemma is reminiscent of the so-called “Greenspan conundrum” of 2004, when long-term yields kept falling even as then-Fed Chairman Alan Greenspan ratcheted up borrowing costs more than 4 percentage points. The market thwarted his attempts to tighten credit and curb excesses that contributed to the worst financial crisis in 80 years.

Yield Spread

Yields on benchmark 10-year Treasuries fell again last week -- 0.12 percentage point to 1.84 percent -- as a government report showed employers in March added the fewest workers since December 2013. The 126,000 increase was weaker than the most pessimistic forecast in a Bloomberg survey, damping the outlook for the timing of a rate hike. The yield gained six basis points to 1.90 percent at 1:29 p.m. in New York.

Dudley, who is vice chairman of the policy-setting Federal Open Market Committee, in a speech Monday, reinforced Chair Janet Yellen’s message that borrowing costs are likely to remain low after the Fed raises its benchmark rate.

“The path will be relatively shallow” as “headwinds in the aftermath of the financial crisis are still in evidence,” he said in Newark, New Jersey.

If financial conditions don’t tighten much in response to a Fed rate increase, then the central bank may have to move more quickly, Dudley said. On the other hand, if conditions “tighten unduly,” that would probably cause the Fed to raise rates more slowly or even pause.

A New York Fed model that analyzes bond yields shows investors aren’t demanding any compensation for the risk that long-term interest rates will change. A measure known as the term premium has been negative off and on since 2012, the year the Fed started its third round of bond buying.

Fed Tool

While those asset purchases may have helped distort prices, they have also given the Fed the option of selling bonds as part of its exit strategy, a tool to increase long-term yields that Greenspan didn’t have.

There’s a risk associated with a more aggressive tightening: Raising benchmark borrowing costs higher may choke off the recovery by discouraging banks from extending credit. Lenders typically finance long-term loans with near-term debt, and an inverted yield curve usually precedes a recession.

Raising rates too quickly “could be dangerous,” said Todd Hedtke, vice president in Minneapolis at Allianz Investment Management, which oversees $100 billion in assets. “The Fed is going to be careful here.”

Bond investors seem to see nothing wrong with the status quo. Individuals have poured $39.7 billion into fixed-income mutual funds this year, compared with $43.5 billion for all of 2014, according to the Investment Company Institute. By comparison, they’ve sent just $6.7 billion into mutual funds investing in U.S. stocks in 2015.

Term Premium

“Everybody knows the Fed is going to raise rates, they don’t seem to be bothered by it right now,” said Jim Bianco, president of Bianco Research LLC in Chicago. “There’s no real threat of inflation.”

While the term premium’s negative 0.23 percentage-point gauge on April 3 suggests Treasuries are expensive, the measure usually hasn’t climbed when the Fed’s raised rates in the past.

In eight tightening cycles going back to 1972, it’s risen three times in the six months after the Fed moved, according to data compiled by Bloomberg. During the other five periods, it was either little changed or fell, suggesting long-term Treasuries remained at existing prices or rallied.

BlackRock Inc.’s Jeffrey Rosenberg says the bond market’s too complacent and is poised for a correction. Treasuries gained for the fifth straight quarter ending last month, the longest streak since 1998.

The Fed has “a tremendous ability” to send bond yields higher, particularly after debt purchases ballooned its balance sheet to a record $4.5 trillion, said Rosenberg, chief fixed-income strategist for the world’s biggest asset manager.

Rate Outlooks

Rosenberg predicts 10-year Treasury yields will climb about 0.7 percentage point to 2.5 percent by year-end. That’s about in line with the median forecast of 75 analysts in a Bloomberg survey.

“We don’t think the Fed needs to worry about a conundrum 2.0,” he said.

Benchmark yields have fallen this year in spite of the Fed’s talk of raising rates for the first time since 2006. While policy makers last month dropped their commitment to be “patient” before tightening, they also moved closer to the market’s view by cutting their outlook for borrowing costs.

Fed officials now predict benchmark rates at the end of this year of 0.625 percent, down from a December estimate of 1.125 percent. The market adjusted lower too, and priced in a rate of 0.34 percent, based on data compiled by Bloomberg.

The spread between the Fed’s target rate for overnight loans and yields on 10-year Treasuries suggests nothing’s really out of whack. The spread is 1.59 percentage points, versus its average of 1.47 points during the past 20 years.

“If the burden of proof is on anybody, it’s on the Fed,” said Stewart Taylor, a Boston-based money manager at Eaton Vance Management, which oversees $86 billion in debt.

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