Did the Fed blow it?
Greenspan & Co.'s wishy-washy words, deeds mean they can do little to push bond rates down again.
June 26, 2003: 5:20 PM EDT
By Mark Gongloff, CNN/Money Staff Writer

NEW YORK (CNN/Money) - In their continuing effort to influence investor sentiment, Alan Greenspan and his team at the Federal Reserve - Robert Parry excepted -- unintentionally did their best Wednesday to ensure that the glory days of low interest rates are a thing of the past.

There's one caveat, of course: If the economy sinks again, interest rates will surely sink as well -- great news for Treasury bond investors, maybe, but a disaster for the broader economy, and certainly nothing for which the Fed would want to take credit.

A worsening economy would eventually fuel deflation, and low interest rates wouldn't mean much. In that scenario, the Fed would be powerless to help, as it admitted Wednesday.

In effect, the Fed showed it was running out of ammo by cutting a smaller-than-expected quarter-percentage point -- hanging on for dear life to the last quarter-point cut in its "arsenal" -- and by telling the Wall Street Journal that its earlier talk about "unconventional warfare" (buying long-term Treasurys, mostly) was about as believable as a "triple guarantee" from the Iraqi Information Minister.

So the Fed has taken itself out of the game -- with one exception, which I'll mention in a minute -- leaving bond traders to rely mostly on their outlook for the economy when setting bond yields. If that's so, then yields are probably going higher.

The peak has passed

Nearly everyone in financial markets thought the central bank's policy makers were geniuses back in May and early June. The Fed's May 6 statement implying that interest rates were staying low for some time fueled a Treasury rally that lopped about a half-percentage point from the 10-year Treasury yield.

After that, the Fed's talk about unconventional methods, along with hints it was planning an aggressive rate cut for June 25, drove the yield on the 10-year Treasury note as low as 3.08 percent on June 13.

Was that rate too low? Maybe so. But in the weeks since, a corrective cocktail, including the Fed's cut Wednesday and its backpedaling on long-term bond buys, has sent the yield on the 10-year note back up near 3.50 percent. That's a big swing, and it's bad news for rates on mortgages and other loans.

That in itself could hurt -- not help -- the economy, since the housing market has been such a huge engine of growth.

Worse still, the Fed's June 25 statement was slightly more optimistic than its May 6 statement. If the Fed was trying to convince the bond market that low rates were just as much of a sure thing as they were back on May 6, it picked a strange way to say that.

"The Fed has again tried to be all things to everyone and ended up being nothing to nobody," Drew Matus, financial economist at Lehman Brothers, told Reuters Wednesday.

In effect, the Fed erased all of the Treasury market's June gains; we're back to where we were in mid-May, which may not be so bad. But where does the bond market go from here?

For one thing, unless there's an economic disaster, we'll likely not see 3.08 percent on the 10-year yield again. If the economy is stronger in the second half -- as most economists keep promising it will be -- then interest rates will certainly head higher.

But the Fed does have at least one tool at its disposal. By keeping short-term rates low, it can effectively keep a lid on long-term rates, since long rates are mostly just a bet on a bunch of short rates. Still, that's a far cry from the sort of aggressive juicing that the central bank's rate cuts are supposed to offer.

"Longer-term rates will not rise dramatically as long as the Fed keeps the short-term policy rate at 1 percent," said David Kotok, chief investment officer at Cumberland Advisors. "However, the pressure for upward movement in bond rates is already there and will persist."  Top of page

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