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Never say never
Why was the market reaction to the Fed's language shift so big?
January 29, 2004: 1:21 PM EST
By Justin Lahart, CNN/Money senior writer

NEW YORK (CNN/Money) - This just in from Washington: Saying a "considerable period" isn't the same thing as saying "forever."

It seems an easy distinction, but judging from Wednesday's market action, many investors had lost sight of it. The Fed went from saying it could keep rates low "for a considerable period of time" -- what it had been telling us since August -- to saying it "believes it can be patient in removing its policy accommodation," and the stock and bond markets sold off big time.

The Dow fell 141 points on the day. The 10-year Treasury fell nearly a full point, pushing its yield up to 4.19 percent. How could such a little shift in language prompt such a big reaction?

Low rates and strong economic growth are about as close to Nirvana as it gets for investors and, aided and abetted by the wagging of Fed officials' jaws, many investors had come to bank on that situation persisting throughout the year.

Indeed, at the beginning of this month Fed governor Ben Bernanke gave a speech that many observers came to think of as the central bank's roadmap for the year. In it he argued that rising commodity prices were due to factors we hadn't seen in past cycles, and that they didn't represent a risk of future inflation as a result. He also said that the economy's output gap -- the difference between how fast it is growing and how fast it would grow if it were running at full capacity -- remains wide.

The message to the market was that the Fed is going to keep its foot firmly on the accelerator. Bernanke's comments sparked a massive rally in Treasurys in the days that followed. Suddenly, that message got taken away.

This threw a big wrench in the equity valuation models many professional investors use, which allow for higher price-to-earnings ratios when interest rates fall on the theory that the low returns that fixed-income investments offer make stocks more attractive. With visions of 1994, when the Fed hiked rates massively, dancing through portfolio managers heads, fingers reached for the sell button.

"From both behavioral models and anecdotal evidence from client meetings, we know that there is a huge number of people who use these kinds of valuation metrics," said Dresdner Kleinwort Benson global investment strategist James Montier. (Montier is a critic of these models.)

The bond market reaction was, if anything, more worrisome than the stock market decline.

Oftentimes, when the Alan Greenspan & Co. start acting tougher, Treasury investors rejoice. In early 2000, for example, when the Fed began to say the economy risked overheating, and raised rates to temper that risk, Treasurys began to rally big time.

This makes sense. When the Fed starts to lean against the economy, the risk of inflation falls and economic activity slows, making Treasurys a more attractive investment alternative to stocks.

So why did Treasurys fall Wednesday? The problem is that, because of the Fed's many promises over the past year that it had no plans to raise rates, many financial institutions have been taking advantage of the difference between short-term and long-term interest rates.

To do this, they borrow at the short-term rates and lend at the long-term rates, pocketing the difference. This, in turn, pushes long-term rates down. The danger of these carry trades, as they are called, comes when short-term rates rise, forcing rapid unwinding. But those dangers get ignored when Ben Bernanke is telling you not to worry.

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Written by: Justin Lahart

"Now the game has changed and there's a greater risk of capital loss," said Miller Tabak bond strategist Tony Crescenzi. "Banks won't take as many chances now."

The last time financial institutions got heavily involved in carry trades was (you guessed it) 1993 -- a big reason that the Treasury market got hammered so badly in 1994.

Folks, it could be a real interesting year.  Top of page




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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.