Commentary > HaysWire
A messy Fed divorce
Time for the bond market and the central bank to dry their eyes and move on.
August 12, 2003: 11:08 AM EDT
By Kathleen Hays, CNN/Money contributing columnist

NEW YORK (CNN/Money) - Heaven hath no rage like love to hatred turned, Nor Hell a fury like a woman scorned.

That was written by William Congreve, a poet who was famous 300 years ago. But he could have been writing about the U.S. government bond market today, which sold off in a fury after its rosy belief that the Fed would keep rates falling indefinitely was shattered.

But as the Federal Reserve meets today, and bond traders wait for the outcome, it may be time to realize that no matter how painful and messy the break-up, the parties involved must put it all behind them and move ahead with their financial lives. Bond traders are doing that by focusing on the fundamentals of the economy, which may mean they are less willing to be swayed by anything the Fed says in its policy statement today.

"I've lost all faith and confidence in the Fed. If the Fed was hoping to keep interest rates low, it's backfired," one bond trader e-mailed me recently. "The bond market is now issuing judgment on Fed policy and traders aren't buying the deflation story."

"Worse, Joe Six-Pack has no idea that when interest rates rise, the value of his bond mutual fund falls," he added. "Get this, investors have now lost more money in principal this year than they have gained in interest...The Fed has lost its credibility."

Recall that 10-year Treasury note yields fell as low as 3.07 percent in June, only to spike up nearly to 4.60 percent in July -- it was the worst sell-off in the bond market in nearly 20 years, and it no doubt has cost many traders and investors dearly.

Bond traders claim that the Fed misled them with its talk of what measures it might take to deal with the remote possibility of deflation, including the last resort of the Fed buying up quantities of notes and bonds to push down bond yields and stimulate the economy. When the Fed did not follow through with an aggressive half-point rate cut at its June 25th meeting, and when Greenspan told Congress the Fed decided extraordinary measures would probably not be needed, bond traders were caught totally wrong-footed.

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Defenders of the Fed, like Bob Ried of Ried, Thunberg and Co., say "All Greenspan did was validate investors' worst suspicions, that is that the economic outlook was optimistic and any further ease in monetary policy was unlikely as was the use of non-conventional policy tools."

"Plus, investors realized that given historically low yields, once a reversal began it was likely to be a doozy," Ried added in a recent e-mail

That may be the voice of reason, and it's certainly what Fed officials themselves must be saying to defend themselves and justify a strategy that many bond traders describe as clumsy at best, and downright stupid at worst.

"I guess the real question here is, what is the cost of bond market volatility and what is the cost of the Fed's miscommunication with the market?" said James White of Excelsior Capital Management in a recent interview with me on CNN Money Morning. "They went out and told everybody to buy bonds and then they cut their legs off."

To the degree that feeling of betrayal remains among some bond players, there may be nothing the Fed can say today in its policy statement to talk traders and investors into buying bonds. What the Fed may have forfeited is any ability to jawbone the bond market into lowering yields by purchasing lots of bonds, something that would also help bring down mortgage rates.

On CNN Money Morning, former Fed vice-chair Alice Rivlin told me she thinks the Fed will try to soothe the bond market by saying growth is marginally better but unemployment is still a problem, and by saying it's still worried about the threat of deflation, no matter how minor.

The worse thing the Fed could say for bond traders may be the best thing they can say for stock traders: the economy is gaining momentum, tax cuts are working, and jobs will start growing soon. That would be great for stocks because it would give official Fed blessing to the bullish equity camp. But potentially not as great for bonds, because it would convince the bears that rate hikes are coming sooner rather than later.

With the pain and anger of the July bond sell-off still lingering for some bond traders, there may be nothing the Fed can do to talk yields lower. Like the old song says, breaking up is hard to do.  Top of page

Kathleen Hays anchors CNN Money Morning and The FlipSide, airing Monday to Friday on CNNfn. As part of CNN's Business News team, she is also a regular contributor to Lou Dobbs Tonight.

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