Next Step for Bond Yields May Depend on Inflation
For bond issuers and their investors, the next move in long-term interest rates may depend less on further Federal Reserve rate cuts than on price cuts at the retail checkout counter.
Only an easing of inflation pressures may do the trick in coaxing long-term rates--including mortgage rates--down from current levels, some analysts contend.
Many bond market pros believe the Fed is nearly done reducing its key short-term interest rate, which with Wednesday’s quarter-point cut has fallen from 6.5% to 3.75% this year.
Though the Fed’s credit-easing campaign has pulled other short-term rates down this year, the central bank doesn’t directly control long-term rates. Those are set by investors in the marketplace.
Long-term bond yields plunged last year as the economy began to slow and as investors anticipated that the Fed would begin to loosen credit.
But this year, almost as soon as the Fed began to cut short-term rates, long-term rates stopped falling. And by spring, bond yields were resurging, in part as investors bet that an economic rebound would get underway in the second half of the year--fueling demand for money, and potentially, higher inflation:
* The 10-year Treasury note yield, a benchmark for many other long-term rates, sank from 6.7% in January 2000 to 5.1% by the start of this year. The yield rose modestly in January, fell again by late March, then resurged in April and May, reaching 5.5% by late May.
On Wednesday, the 10-year T-note inched up to 5.24% from 5.22% Tuesday.
* The yield on an index of AA-rated corporate bonds tracked by Moody’s Investors Service dropped from 8.3% in May 2000 to 7.1% by late March, but has since rebounded to 7.32%.
* Thirty-year mortgage rates, as tracked by mortgage giant Freddie Mac, hit a low of 6.89% in mid-January. As of last week, Freddie Mac’s rate was 7.11%.
James Bianco, head of bond research firm Bianco Research in Barrington, Ill., contends that “the bond market believes that [Fed Chairman Alan] Greenspan is not fighting the inflation fight.”
Investors, Bianco said, are refusing to allow long-term yields to drop further because they’re worried that the Fed’s easy-credit policy will translate into strong inflation pressures in 2002 and beyond. Inflation erodes returns on fixed-rate bonds.
But Greenspan has argued that the jump in the consumer price index this year, to an annual rate of about 3.5%, is largely because of higher energy prices, which are falling.
Many economists think Greenspan is right. Robert V. DiClemente, economist at Salomon Smith Barney in New York, said the inflation outlook “has improved dramatically.”
Still, bond investors want to see proof before they allow yields to drop, said Randy Merk, bond portfolio manager at American Century mutual funds in Mountain View, Calif.
“We need the CPI to come through” with smaller increases for the rest of this year, he said.
Merk argues that there is still a high risk that the economy won’t revive significantly soon. He believes the Fed should have cut rates by another half point, rather than a quarter point, on Wednesday.
“I would have preferred a bolder step,” he said.
If the economy does continue to slow, that could lead to lower bond yields by fall, some analysts say--provided inflation hasn’t worsened.
Bond yields also have been held up this year by surging corporate issuance of new bonds--despite the weak economy. In many cases companies are refinancing older, higher-cost debt.
Some economists have argued that companies’ willingness to borrow shows that the real cost of money--the after-inflation cost--is attractive. Moreover, high debt issuance could be a sign that some companies believe it’s smart to lock in current rates because they expect inflation, and interest rates, to rise in coming years.
Other analysts, however, say many companies are borrowing simply because they still can.
As for mortgage rates, they too have been held up in part by a wave of refinancings. But over time mortgage rates take their cue from bond yields.
For now, the latest Fed move “should not make any difference in mortgage rates” in the near term, said Doug Duncan, an economist with the Mortgage Bankers Assn. of America.
The MBAA expects to see a small increase in mortgage rates in the third and fourth quarters, assuming the economy’s growth rate doesn’t deteriorate further.
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Times staff writer Diane Wedner contributed to this report.
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The Fed Moves Again
The Federal Reserve on Wednesday cut its target for the federal funds rate, a key short-term rate in the U.S. banking system, to 3.75% from 4%. The trend in the fed funds rate since 1990:
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Federal funds rate Wednesday: 3.75%
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Outlook for Other Interest Rates
With the Fed’s decision Wednesday to cut its key short-term interest rate by a quarter point, here’s a look at what may happen with other lending and investment rates in the near term:
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Item: Prime lending rate
Current rate: 6.75%
Change since previous Fed cut (May 15): -0.25 pts.
Outlook: Banks reduced the prime in tandem with the Fed’s cut Wednesday. So the prime-a benchmark for many consumer loan rates-should stay at this level for now.
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Item: Money market mutual fund average yield (seven-day)
Current rate: 3.62%
Change since previous Fed cut (May 15): -0.52 pts.
Outlook: True to form, money fund yields have tracked the Fed’s last move, falling about a half-point since May 15. With the latest cut, yields should drop a quarter point in coming weeks.
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Item: 1-yr. CD yield (U.S. avg.)
Current rate: 3.76%
Change since previous Fed cut (May 15): -0.40 pts.
Outlook: CD yields have tumbled this year with the Fed’s cuts, and at best may stabilize near current levels, some bank analysts say. It’s best to shop around for the best deals.
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Item: 10-year Treasury note yield
Current rate: 5.24%
Change since previous Fed cut (May 15): -0.26 pts.
Outlook: Long-term bond yields have pulled back since May, but still are above their March lows, even as the Fed has cut short-term rates. Investors want to see inflation pressures ease before they’ll allow bond yields to drop much further, analysts say.
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Item: 30-year mortgage rate (Freddie Mac)
Current rate: 7.11%
Change since previous Fed cut (May 15): -0.03 pts.
Outlook: Mortgage rates take their cue from long-term bond yields, so the latter will have to slide further for mortgage rates to come down significantly from current levels.
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Note: Money fund and CD yields are compound yields.
Sources: IMoneyNet.com, Times research
