Greg Ip Reads the Mind of the Fed

He writes:

WSJ.com - Fed Sees Bond Market Hampering Its Steps to Keep Inflation in Check: By GREG IP: WASHINGTON -- As the Federal Reserve prepares to raise short-term interest rates again next week, officials there increasingly believe the bond market, which sets long-term rates, is diluting their efforts to tighten credit and contain inflation. The result: The longer the bond market keeps long-term rates unusually low, the further the Fed is likely to raise the short-term rates.... This dynamic marks a striking break from the past when the Fed typically saw sharply higher bond yields as a reason to lift short-term rates further and low yields as a reason to worry about the economy.

Fed officials say future rate moves mostly depend on what data indicate about growth and inflation. With inflation low but the economy steadily using up unused capacity, officials plan to keep raising short-term rates to... a level... between 3% and 5% that neither stimulates nor restrains economic growth.... Some policy makers worry that bond yields are being kept in check by overly complacent investor sentiment which could rapidly dissipate, pushing up mortgage rates and shaking the housing market.... The Fed is expected to raise the short-term rate to 3.5% on Tuesday. Since June of last year, the Fed has raised the Fed funds rate target from a 46-year low of 1% to 3.25%.

Yet, over the same period, the yield on the benchmark 10-year Treasury bond has declined. It fell from 4.7% to below 4% a month ago, although its has bounced back up to 4.3%.... If "special factors," such as increased investor confidence that inflation will remain low, or purchases of bonds by foreign central banks, are the reason for low bond yields, "the federal-funds rate probably needs to be somewhat higher than would otherwise be appropriate," Ms. Yellen said. But if the market is anticipating hard economic times, "a somewhat easier policy may be appropriate," she said. In the past month, other key Fed policy makers have come to view special factors as the likelier explanation for low long-term rates than [beliefs in future] economic weakness.... Mr. Greenspan last month strongly suggested that he thought investors may be complacent. "Risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons," he said. "Long periods of relative stability often engender unrealistic expectations of its permanence and, at times, may lead to financial excess and economic stress."...

Comments

[Ian D-B]

well maybe not now that inflation has been revised up...

[shah8]

Those guys are *really* fighting the Fed, aren't they?

Wonder who's going to win?

[Ian D-B]

I thought well anchored inflation expectations were supposed to make monetary policy work better.

[anne]

The most immediate problem for housing may be in the process of developing immediately, if in fact China is beginning to diversify its currency holdings. Other Asian central banks as well will surely diversify currency holding from the dollar.

[anne]

We should notice that China is very slowly letting the yaun rise against the dollar, and long term interest rates are slowly rising. This could easily become a problem for our mortgage market, and we had best watch interest rates.

[anne]

Likely there is and will continue to be less international demand for long term Treasury debt as Asian and other central banks slowly limit dollar holdings.

[anne]

If the Federal Reserve governors wish higher long term rates, the guess is they will have the wish. We should be worried. Inflation, by the way, seems to me of no concern in this cycle, but I am not a member of the Fed :)

[chris]

Stockman in the post above mentions inflation in material prices for a car part supplier to the Big 3 automakers, I guess. "He attributed the "unfortunate losses" suffered by stock and bond holders -- himself included -- to an "industry meltdown" caused by soaring raw-materials prices and the refusal of car makers to offer relief."

Considering in Winter 2004 Greenspan supposedly approved ARMs by commenting on how much money could have been saved by mortgage holders if they had used mortgages that ratcheted down in rates, and now he seems to warn of possible increases in rates after a year's worth of buying ARMs, "Mr. Greenspan last month strongly suggested that he thought investors may be complacent. 'Risk takers have been encouraged,'" should we be relying so heavily on our Fed Chairman? With the Federal debt increasing at its current rate won't he have to raise rates to attack bondholders?

[bakho]

Chris- "inflation in raw material prices" primarily refers to steel. Steel can be made from ore (expensive) or can be remade from scrap (cheap). China went on a worldwide buying spree that sent prices for steel scrap soaring worldwide. This increased steel costs to parts mfg.

However the parts mfg were squeezed by contracts with automakers that locked in prices based on much cheaper steel prices. Steel prices have since dropped, but many parts mfg lock in long term (1 year) contracts for steel. So the parts mfg are stuck with high steel prices until the new steel contracts are signed.

Steel prices have inflated far faster than the average rate of inflation.

[christo]

Bakho:

Got ya explanation. I meant there is or was inflation at that level of the economic machine if not at the reported CPI level. And inflation at that level hurt a company that was employing well-paid Michigan and Indiana and wherever workers. I included that as a poster above wrote, "If the Federal Reserve governors wish higher long term rates, the guess is they will have the wish. We should be worried. Inflation, by the way, seems to me of no concern in this cycle, but I am not a member of the Fed :)"

I could have included a lot of things but wanted to keep the post short to get to my question, won't the Fed's hands be tied about rates as they might have to worry about finding investors for our Arnold-sized deficits?

If I wanted to go to a longer post I'd include while reported corporate profits are high, they are profits from the finance side. GM doesn't make money making cars. And manufacturing companies are having a hard time being squeezed by material inflation in an environment where they can't raise prices.

"Steel prices have inflated far faster than the average rate of inflation." I agree. But inflation at this level doesn't concern, let me slip this in here, Mr Magoo. It does hurt the manufacturing, employing our fellow citizens, segment of the economy. It doesn't affect the borrowing to speculate segment of the economy.

As Beck sings, "I'm a termite choking on a splinter." Off a McManshion I wonder.

[anne]

Looking through the data again, inflation appears to have peaked for the cycle at a level lower than an Fed tightening cycle since at least 1975. Inflaion is no an issue, especially inflation due to wage and benefit increases.

[Tom Cecere]

The thing that occurred to me after reading this was that 3 years from now, will the Fed be frustrated by the Bond Market's refusal to reduce long term rates? We have been complacent about the notion that the Fed can (over time, and not delicately) have an impact on rates, but the twin deficits and the relative reduction in US-to-Rest of World GDP may have left his historical phase behind us.

And, what happens to foreign policy if we blame other countries for our high interest rates? Can't you see it? "If only China would revalue their currency, I could get a home equity line!"

[anne]

Tom Cerere

'And, what happens to foreign policy if we blame other countries for our high interest rates? Can't you see it? "If only China would revalue their currency, I could get a home equity line!"'

Clever :)

[Mark Sullivan]

RE: china and long term bond prices.

The bond market reacted more to second quarter earnings and GDP news than to the china exchange rate announcement. Some bond investors have been expecting the fed to halt the rate increases as the economy cools due to previous increases (remember the soft spot?). Recent economic news has made it clear that there is no cooling, the fed can continue slowly raising, and the bond market is (slowly) reacting. Note that it is not just US Treasury prices that have been depressed. Bond prices have been depressed across the dollar-denominated fixed income market.

China is big, but the fixed income market as a whole is much, much bigger. Investors are holding these prices down, not foreign central banks. Some combination of low real fed fund rates, lack of other investment opportunity and perceived low inflation and default risk make bonds of all sorts look attractive, even at these rates.

[Mark Sullivan]

re: bond prices have been depressed.

Yikes, I meant yields have been depressed.

[AllenM]

How will rates adjust higher? In a measured fashion like Greenspan wants, or a blind panic like the market usually does? I bet on the blind panic scenario. With my own money. And if I am right I will have more money. Now that is the true definition of putting my money where my mouth is. The market is driven by many short term dynamics to ignore the macro scene. when reality bites, and it will, they will be on the short end of the stick.

[Jonathan Cole]

' I bet on the blind panic scenario. With my own money. And if I am right I will have more money. '

Sorry if I seem ignorant but exactly what position have you taken? I need to learn how to capitalize on what appears to be an impending flight of funds from this sector of the capital markets.

Thanks.

[James]

Jonathan,

The easiest way to profit from rising bond prices is to sell bonds short. This can be done directly or with derivatives. The easiest method for small investors is using bond fund etfs (such as SHY, IEF, and TLT). Entering the bond market directly is difficult and probably a bad idea if you don't have several hundred thousand dollars. Remember that you have to pay all the interest on any bonds that you sell short. You can also use options to trade on price changes, which allows increased leverage (which is good if you are right and bad if you are wrong). There are also futures on interest rates, but I don't quite understand how they work.

If you are certain that bond prices will fall, the most profitable thing to do is almost certainly selling call options on bond etfs. Do your analysis carefully, because if prices rise or even just don't fall soon enough, you can lose a lot of money that way. I am not in any way an investment advisor and accept no responsibility for any money you lose based on what I have said.

[James]

I meant to say "profit from rising interest rates", not "profit from rising bond prices". Obviously selling bonds short will lose money if bond prices go up.

[Jonathan Cole]

James,

Thank you very much for the information. I will not hold you to anything you said, and I will certainly study the issue before doing anything. You are correct that I do not have a couple a hundred grand that I can afford to lose so I will need a lower entry point. Puts are interesting but scary, Ill study this further.

Thanks again for the response James.

[AllenM]

I rarely talk about what a common person can do, mainly because a common person usually gets treated like a bug on the windshield by the markets. I had a very large house sale transaction to basically insure for eight weeks. I took a position in 30 September92 TLT put contracts that provided enough protection to offset a potential spike in interest rates above 6%, a level that would have allowed the buyer to void the contract. The potential profit was $82,500 if the interest rate on the 20+ treasury long bond went over that by the closing date in Spetmeber. I have since closed that transaction as the need to hedge has mitigated due to financing in place and committed to the transaction. I will note that the hedge has still returned 65% from the purchase on june 30 till close today. I would suggest that anybody who desires to trade options buy about twenty books and then lose about 20K to really begin to understand the option market- it is not for the faint or poorly capitalized.