Bond Investors May Nix the Fed's Sweet Talk

Be skeptical of the idea that the Federal Reserve will be able to unwind its huge balance sheet and normalize the overnight rate without creating havoc in the bond market.

Bloomberg News reporters Liz Capo McCormick and Dan Kruger have an article out today: "Bond Buyers See No 1994 as Bernanke Clarity Tops Greenspan."

No one will take issue with the clarity part. Former Federal Reserve Chairman Alan Greenspan made an art form of obfuscation. Ben Bernanke, on the other hand, has elevated communication to a "policy tool." I will leave it to the reader to assess when too much is enough.

I'm skeptical, however, of the idea advocated by so many bond investors in the Bloomberg article: that the Fed will be able to unwind its huge balance sheet and normalize the overnight rate without creating havoc in the bond market. Just look what happened Friday on a very unspectacular employment report: Yields on 10-year and 30-year Treasuries rose about 11 and 13 basis points, respectively. What's going to happen if the economy starts delivering really good news on a consistent basis?

Now it's true that the long-term rate is the sum of the current and future expected short-term rates. So if the Fed continues to guarantee a zero percent funds rate until 2015 or such a time when the unemployment rate falls to 6.5 percent, that will keep long rates from getting too far ahead of the Fed.

The neutral funds rate, or what will keep the economy growing at its non-inflationary potential in perpetuity, was always thought to be something in the neighborhood of 4 to 4.5 percent. Perhaps things have changed, and that figure is actually lower. Even so, we know that zero isn't normal. And it's hard to see how rates can move from zero to 4 percent without causing major dislocations in the bond market, especially since the market generally smells a turn well before the Fed's models suggest time to reverse course.

It's also unclear which has been the greater depressant on long-term interest rates: the Fed's large-scale asset purchases or the weak economy. The Fed says it has the tools to deal with any upward pressure on interest rates from sales of its securities portolio, even if it entails holding some to maturity.

If it turns out that the weak economy is the reason, and the data show significant improvement, then Friday's sell-off may be a taste of things to come.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.