Is the Fed Losing Control of Interest Rates?

Investors who thought the bond market had already gone from bad to worse are searching for new superlatives, after Friday's massacre.

Some also are searching for fresh derogatory terms with which to describe the Federal Reserve Board, whose policies are once again being criticized as dangerously misguided.

On Wall Street, short- and long-term interest rates rocketed on Friday after the government reported a surprising surge in new jobs in April, more proof that the national economy is humming along.

Traders of short-term Treasury bills, convinced that economic strength will force the Fed to raise the cost of money further, pushed the yield on three-month Treasury bills from 4.13% on Thursday to 4.29% on Friday--a yield last seen in the fall of 1991.

In the long end of the bond market, meanwhile, the yield on the bellwether 30-year Treasury bond closed at 7.55% on Friday, up dramatically from 7.33% on Thursday and the highest in 17 months.

In theory, at least, long-term yields jumped not because the Fed is expected to officially boost short rates again, but because it didn't do so on Friday.

If Fed Chairman Alan Greenspan is serious about restraining the economy and thus inflation--the No. 1 worry of long-term bond investors--why wouldn't he demonstrate that by acting forcefully to tighten credit in the face of the robust April jobs report?

The easy answer to that is, the independent Fed does as it pleases. With a meeting of Fed governors already planned for May 17, Greenspan & Co. may feel there's no rush to engineer what would be the fourth official hike in short rates since Feb. 4.

But some economists believe the Fed is making the same alleged mistake in raising rates that it made while cutting rates between 1990 and 1993: It's going too slow and is in danger of losing control of the economy and interest rates.

As the economy languished in 1991 and 1992, the Fed for the most part continued a gradualist policy of small rate cuts every few months. Some economists argued throughout that period that the economy needed shock treatment--deep rate cuts, on the order of one percentage point at a time--to get moving again.

But the Fed wasn't intimidated by its critics. Though it's impossible to say for sure, the Fed's tortoise-like pace may have needlessly prolonged the economy's slump. At the very least, it helped cost George Bush the presidency.

Now the Fed is on the opposite side of the interest-rate curve, and again its critics say its gradualist policy carries too many risks. Mainly, the risk is an overheated economy.

"I think the Fed should hurry up," argues Allen Sinai, chief economist at Lehman Bros in Boston. Greenspan's policy of notching short-term rates up a quarter-point at a time, from 3% to 3.75% so far this year on the so-called federal funds rate, clearly isn't viewed as strong enough medicine by the bond market, Sinai said.

"I would (boost) one-half point on fed funds immediately," he said. Yet he warns that the Fed may already be too late to forestall more trouble in the bond market this week: Wall Street must cope with the Treasury's quarterly refinancing on Tuesday and Wednesday, which will dump $29 billion (total) in new 3- and 10-year notes on the market.

In addition, loss-ridden bond owners may decide to bail early this week rather than wait for the government's reports on wholesale and consumer inflation in April. Those reports are due Thursday and Friday, respectively, and could whip up more bond market hysteria if the numbers suggest inflation is rising even marginally over the 2.5% to 3% annualized rate now thought to be "acceptable."

Also worrisome for bond investors are recent signs of surprising strength in the economies of some major U.S. trading partners, including Germany.

"Not only might bonds be ravaged by increased inflation risks, but faster growth throughout the industrialized world will push real interest rates higher" more quickly than expected, warned John Lonski, economist at Moody's Investors Service in New York.

He predicts the 30-year Treasury bond yield will hit 7.8% by midyear, further spooking investors who desperately want to see long-term yields stabilize.

While Sinai and some of his peers worry that the Fed is moving too slowly to subdue growth and potential inflation given the economic backdrop, some Wall Streeters believe the Fed is taking the only course available.

Louis Crandall, chief economist at bond firm R.H. Wrightson & Associates in New York, argues that a dramatic boost in short-term rates by the Fed would be interpreted negatively by the bond market, not positively.

Since February, Crandall said, the bond market's paranoia has been rooted in the feeling that the Fed knows something the market doesn't: In other words, there aren't many significant signs of inflation visible today, but if the Fed is tightening credit (albeit gradually) inflation must loom.

If Greenspan were to suddenly raise rates by, say, a full percentage point to get ahead of the market, Crandall said, the risk is that bond investors would interpret that bold move as a sign that inflation has truly become a problem--and long-term bond yields could leap accordingly.

In any case, Crandall argues, the Fed lost the battle to keep long-term interest rates under control well before the winter's first hike in short-term rates.

By allowing speculation in the bond market to reach unprecedented levels last fall, as short-term rates hung at 30-year lows and investors scrambled to lock in any long-term yield offered them, the central bank set the clock ticking on the current bond market debacle, Crandall said.

"An awful lot of bonds found their way into the hands of people who weren't willing to hold onto them in a bear market," Crandall said. The reason long-term yields have continued to rise this year, even though inflation isn't yet a problem, is that many bond owners are selling out to go back to safer, shorter-term securities as short rates increase, he said.

As long-term bonds flood the market, their prices decline and their yields go up. It's a simple equation, and an incredibly painful one for investors who continue to hold on to bonds as they drop in value and as yields on new securities look so much more enticing.

In a speech on Friday, Greenspan made clear that he understands the nature of the current shakeout in bonds and how it has been made worse by the entry of so many unwary small investors into the bond market last year.

The drop in bond prices this year has been "no doubt exacerbated by significant net redemptions in bond mutual funds, as fund shareholders reacted to declines in net asset values when interest rates backed up," Greenspan said.

Perhaps more important, the Fed chairman offered no apologies to those investors. The turmoil in bonds "can be viewed as an unavoidable correction," he said.

That suggests another possible reason the Fed is content to tolerate the jump in long-term yields this year and not harden its policy to try and stop that surge prematurely: Maybe Greenspan wants to flush the bond market of people who don't belong there.

"We have to get bonds into the hands of a different set of investors now," Crandall said. Unfortunately, that transfer may take a long time and cost many investors much in mental and financial pain.

A Simple Bond Bet: Tired of watching your bond mutual fund share price drop in value? Do you just want to earn a decent yield, without worrying that your principal will be permanently eroded?

Some analysts think there's a simple solution for income-needy bond fund investors who can't stand the thought of losing more principal on paper: Trade your fund for two-year Treasury notes.

The yield on two-year Treasuries jumped to 6.11% on Friday from 5.89% on Thursday. As recently as April 22 the yield was just 5.61%.

Why view 6.11% as a good annual return? John Isaacson, executive vice president at Los Angeles-based bond manager Payden & Rygel, figures it this way:

Three-month Treasury bill yields are now 4.29%, which means the next one or two Fed credit tightenings are already built in. Even if you assume that the Fed keeps raising rates over the next two years, it would take a super-hot economy to justify money market rates above 6%, he said.

"You have to ask what really has to happen (in the economy) for you to earn more than 6.11%" in money market accounts over the next two years, Isaacson said.

And even if short rates do soar above 6%, by owning Treasury notes directly you're still assured of getting all your money back in two years--a promise bond mutual funds can't make.

Or, You Can Hedge: The only good news out of markets on Friday was that some of the classic hedges against higher inflation responded the way they should, given the healthy April employment report: They rose in price.

Gold soared $9.80 an ounce on Friday, to $383.40 on the New York Comex. The price of silver zoomed 32.8 cents to $5.44 an ounce.

Oil, meanwhile, jumped 41 cents to $17.70 a barrel on the New York Merc, boosted by civil strife in oil exporter Yemen and by expectations of higher demand for energy as the global economy improves.

Prices of such disparate commodities as coffee, cotton and copper have been rising this year, though not necessarily because of stronger demand. And some commodities, such as grains, have tumbled on expectations of decent crops thanks to good spring weather in the Midwest.

In any case, if Friday's action is indicative of investors' changing mind-set about the economy, commodities could see a wave of new money flow in. Which means investments such as gold, gold stock mutual funds, energy stock mutual funds and real estate funds may make sense now for investors looking for something that might rise in price if bonds and stocks continue to slide on interest rate worries.

Seeing Red on Inflation

Prices of some commodities have been surging in recent weeks, adding to the bond market's worries about higher inflation ahead. But in key commodity markets, such as grains, prices have been moving down, not up.

Chng. since Commodity Jan. 1 April 1 Fri. Jan. 1 Coffee (pound) $0.72 $0.82 $1.04 +44.4% Oil (barrel) 14.17 14.79 17.70 +24.9 Copper (pound) 0.83 0.87 0.96 +15.7 Platinum (ounce) 394.90 423.20 399.00 +1.0 Gold (ounce) 390.80 391.80 383.40 -1.9 Soybeans (bushel) 7.04 6.82 6.68 -5.1 Wheat (bushel) 3.78 3.30 3.23 -14.6 Corn (bushel) 3.06 2.75 2.59 -15.4

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