Bond Yields Tell Different Tale Than Fed

Officially, the Federal Reserve Board still is worried that the U.S. economy is too strong and that higher interest rates might be needed to slow growth and subdue inflationary pressures.

But financial markets seem to have a much different view of the central bank’s probable next move with rates--namely, a cut rather than an increase.

For U.S. consumers and businesses, the stakes are significant either way, of course. A rate boost by the Fed could depress economic activity and make credit tougher to get. A rate cut could have the opposite effect and thus naturally would be welcomed by households and businesses.

The markets’ apparent optimism about a rate cut was reflected last week in a rare occurrence: In the U.S. Treasury bond market, yields on bonds of every maturity--from three-month Treasury bills to 30-year Treasury bonds--were below the Fed’s benchmark short-term interest rate, the federal funds rate.

Normally, the federal funds rate, which is what banks pay to borrow from each other overnight, is supposed to be the “floor” for U.S. interest rates, as set by the Fed.

But while the Fed has been holding the federal funds rate at 5.5% since March 1997, investors late last week pushed the annualized yield on 30-year Treasury bonds to a record low of 5.44%.

That means some investors now are willing to accept a lower rate to commit their money for 30 years than they could earn in some short-term money market funds.

It doesn’t take an economics degree to understand the seeming illogic there. Long-term interest rates are supposed to be higher than shorter-term rates to compensate investors for the greater risk entailed in tying up their money at a fixed rate for an extended period.

Then why have Treasury bond yields fallen through the Fed’s rate floor?

Historically, that has happened when investors have become convinced that the Fed is on the verge of cutting its key short-term rate.

And because the Fed generally reduces rates only when it starts to worry that the economy needs help to avoid a recession, an interest-rate “inversion”--short-term rates above long-term rates--often has heralded a sharp economic slowdown.

“We’re almost assuredly on course for a slowdown,” said Paul Kasriel, an economist at Northern Trust Bank in Chicago.

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Economist Henry Kaufman at Kaufman & Co. in New York believes that although the U.S. economy might not show outward signs of slowing in the next few months, “chances have improved that [the Fed’s next move] will be to lower interest rates” in 1999.

But those views are far from universal. Indeed, many economists and bond experts argue that the plunge in Treasury bond yields this summer says little about investors’ expectations for Fed policy.

Rather, these experts say, the decline in rates stems largely from a global “flight to quality,” as investors spooked by currency devaluations and general market turmoil spreading from East Asia to Russia to Latin America have flocked to the relative haven of Treasury securities.

Barbara Kenworthy, who oversees more than $8 billion in bond investments for Prudential Investments in Newark, N.J., says investor demand for U.S. Treasury issues has zoomed in recent months because of foreign-market woes and for a host of “technical” reasons, including uncertainty over Europe’s planned monetary union on Jan. 1 and investor wariness about certain higher-risk U.S. corporate bonds.

That increased demand, she noted, is occurring as the Treasury issues fewer new bonds because the federal budget is in surplus for the first time in decades. Thus, there is greater-than-normal downward pressure on yields, as investors must outbid each other simply to get their hands on the bonds.

The U.S. economy, meanwhile, has continued to show amazing strength despite the negative effects of Asia’s deep recession. For example, the housing market remains in a spectacular boom, and claims for unemployment benefits remain surprisingly low.

Last week the Fed released the minutes of its July meeting, and the transcript showed that some Fed board members, fearful that the U.S. economy might yet overheat, argued that an interest rate hike is needed soon.

But the majority of Fed members voted to stick with a “wait and see” policy on the economy and rates.

Some analysts say the central bank won’t be swayed by the idea that plunging bond yields could be foreshadowing a deep economic slowdown, or recession, and thus that the Fed must “follow the market” by cutting rates.

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For one, bond investors misread the economic tea leaves in early 1996, when they also pushed yields on many Treasury securities below the federal funds rate.

Though the Fed did ease rates modestly in early 1996, the market expected more. When the economy boomed instead of busted, bond yields rebounded sharply.

Given the economy’s current strong trend, “I think the Fed is going to be very slow to cut rates,” regardless of some bond investors’ expectations, Kenworthy said.

Nor will a further slide in U.S. stock prices move the Fed, most analysts argue. Indeed, Fed Chairman Alan Greenspan has broadly hinted for two years that stock prices were too high and should be deflated somewhat to more closely align with the economy’s potential.

Finally, some experts say, Greenspan is wary of sending the wrong signal to the economy, and to investors.

“If they were to cut rates now, some people might say, ‘Things are worse than we thought,’ ” in terms of the Asian economic crisis’ effect on the U.S. economy, said Ray Worseck, an economist at brokerage A.G. Edwards & Sons in St. Louis.

That could, ironically, make a recession more likely if it spooks consumers and businesses.

Still, Worseck is among those economists who believe that the cumulative effect of Asia’s woes, the Russian debt crisis and the growing risk of an economic crisis in Latin America will begin to weigh more heavily on the U.S. economy in coming months.

He believes the Fed will trim the federal funds rate from 5.5% to 5.25% or 5% by year’s end, responding to the slowing economy.

But should the Fed in fact begin easing rates, economists have another concern: whether easier credit in this country would help arrest a continuing downward spiral in Asia that is threatening to engulf Russia, Latin America and other regions.

By creating more financial “liquidity” with a U.S. rate cut, the Fed might not be able to help emerging economies that are most in need of that liquidity, if investors are simply unwilling to invest in those economies.

Unlike in 1987, when the U.S. stock market led other markets lower in the October crash of that year--and the Fed quickly responded by temporarily pushing interest rates lower, boosting investor confidence--this time the financial market crisis is largely foreign in nature.

“I think it’s basically out of our control,” said economist Sung Won Sohn at Norwest Corp. in Minneapolis. While he believes that the world is facing “the most serious economic crisis since the Depression,” the Fed’s power to help with interest rates is limited, he said.

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A Floor No More

The yields investors are willing to accept on Treasury securities of every maturity now are below the Federal Reserve Board’s interest rate “floor,” the federal funds rate, which is at 5.5%. That often signals an economic slowdown.

Federal funds rate: 5.5%

Source: Reuters