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Second-guessing the Fed
Has the economy's 'soft patch' passed? Is inflation about to pop? The bond market doesn't think so.
September 14, 2004: 2:54 PM EDT
By Mark Gongloff, CNN/Money senior writer

NEW YORK (CNN/Money) - If you believe Alan Greenspan when he tells you the economy's recent "soft patch" is over, then you might think the bond market has lost its mind.

After all, bonds have been rallying and interest rates falling -- despite an ongoing Federal Reserve rate-hiking campaign, a supposedly rebounding economy and a pipeline full of inflation.

Could the bond market be making a liar out of the Maestro? Some analysts think so.

"Every time we think the bond market is acting irrationally, we usually find out a month or two later that it was rational, that some people participating in the bond market knew more than most of us economists did -- which is not really a great feat," said Paul Kasriel, director of economic research at Northern Trust.

On June 14, exactly three months ago, the yield on the 10-year Treasury note was 4.87 percent. It had jumped an impressive 32 percent in the prior three months on the expectation that the Fed was about to open up a can of rate-hike to snuff out the threat of inflation.

But since that time, despite two Fed hikes and a third tightening almost certain next week, prices on the 10-year and 2-year Treasury notes have actually gained. Yields, which move opposite to price, have fallen about 15 percent each. That's the most bullish bond reaction to a Fed rate hike on record, according to recent research by Alan Ruskin, research director at 4CAST Ltd., a market and economics research firm.

What's driving the rally?

Oil prices, for one thing, which jumped above $40 a barrel in May and have pretty much camped out there all summer.

As you're probably sick of hearing by now, higher energy prices act as a tax on businesses and consumers. They weaken the economy by raising the cost of doing business and burning up money that could have been spent on fun, discretionary stuff such as whiskey and speedboats.

What's more, stock prices haven't been setting the world on fire. On June 14, the S&P 500 stood at about 1,125. On Tuesday afternoon, exactly three months later, it stood at about ... 1,125.

Meanwhile, after a burst of job growth in the spring, employers got stingy in the summer and barely hired enough people in August to keep up with the monthly growth in the labor force. This and other signs of weakness have fueled doubts about the future health of the economy.

Fed ignores whiners

But Fed policy makers have turned a deaf ear to any mewling by economic girlie-men and doggedly pursued their rate-hiking campaign. As a result, when Greenspan & Co. say they're not going to let inflation get out of hand, long-term bond buyers are true believers.

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"The market's applauding the resolve of the Fed and acting accordingly," said Anthony Crescenzi, chief bond market strategist at Miller, Tabak & Co. "In that way, its behavior is rational."

But lower long-term bond yields also mean the economy is still getting fuel, keeping mortgage rates low and supporting consumer spending. Crescenzi said that, if oil prices don't go any higher, then the economy will adjust to them, giving it additional strength.

What's more, Crescenzi and some other analysts believe there are still signs of future inflation. Even last week's Labor Department report on wholesale prices, which showed a benign drop for "finished" goods, also showed a gain for goods in the "intermediate" stage of processing -- the yarn that makes the sweater, for example.

"Over the past year, core intermediate goods inflation has been nearly 5 percentage points higher than core finished goods inflation," Goldman Sachs chief U.S. economist Bill Dudley wrote in a note to clients last week. "This is one of the largest gaps ever, and reinforces our expectation that a part of this early-stage inflation should feed through into finished goods prices in the coming months."

But that's slowly becoming a minority view.

By several measures -- including the latest monthly Merrill Lynch survey of global fund managers, the University of Michigan's monthly consumer sentiment survey and the inflation rate implied by the yield on Treasury Inflation Protected Securities (TIPS) -- inflation expectations have been falling in recent months.

"As opposed to the pundits who claim that there was nothing 'fundamental' behind the bond rally, and that it was only underpinned by the 'soft patch', the reality is that a large chunk of the drop in long-term rates has reflected this adjustment in inflation expectations that is a critical component of any bond market forecast," Merrill's chief North American economist, David Rosenberg, wrote in a note to clients Tuesday.

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Meanwhile, shorter-term interest rates have been busily rising. The federal funds rate, the overnight lending rate targeted by the Fed, has gained about 50 percent, thanks to two Fed rate hikes. The three-month Treasury note has gained 20 percent.

The combination of rising short-term rates and falling long-term rates is generally not good for the economy. The "flattening" of the difference between short and long term rates, in fact, is usually the sort of thing that happens before recessions.

Few economists expect a recession to come any time soon. But the bond market could be saying the economy is vulnerable enough that, if the Fed doesn't soon cool it with the rate hikes, a recession could be in the offing.

"If the Fed pauses here, rates will come down, the house ATM machine will get filled up again, and we can all go back and do more refinancing," said Kasriel of Northern Trust. "But if they keep going, like some people believe they will, then we will have a recession in the second half of 2005."

"But I don't think they will," he added.  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.