Interest rates: The new conundrum

When Alan Greenspan hiked short-term rates, long-term rates barely moved. Ben Bernanke is cutting interest rates but bond yields are rising. Here's what it means.

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By Chris Isidore, senior writer

What the Fed cut means for you
The Fed rate cuts mean you'll take a hit on money market interest rates, but some of your debt will be easier to carry.
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Former Federal Reserve chairman Alan Greenspan and current chairman Ben Bernanke chat at a gathering in Washington, D.C. in October 2007.

NEW YORK ( -- The Fed has lowered short-term interest rates this year but longer-term bond yields have risen. Call it the new conundrum. And it's adding to the confusion on Wall Street about the economy.

In his final year as chairman of the Federal Reserve, Alan Greenspan repeatedly talked about a "conundrum" in the markets. He was referring to the fact that rates for the 10-year U.S. Treasury and 30-year mortgages remained low even as the Fed jacked its key short-term federal funds rate from 1% to 4.5%.

This conundrum didn't go away after the Maestro retired either.

By the time Greenspan's successor Ben Bernanke was done raising rates in June 2006, the yield on the 10-year Treasury stood at 5.22% while the federal funds rate was at 5.25%.

What's more, the 10-year yield was only 0.6 percentage points higher than where it was when the rate hikes began two years earlier. The average 30-year fixed rate mortgage had risen by less than a half-point.

These low long-term rates helped fuel the homebuilding boom and the credit market's appetite for securities backed by increasingly riskier mortgage loans. And it arguably put the economy into the trouble the Fed finds itself dealing with today.

So starting last September, the Fed started trimming rates. And last month, it slashed rates, with two cuts totaling 1.25 percentage points in a little more than a week.

But long-term rates are once again moving in the opposite direction of the Fed: the yields on the benchmark 10-year Treasury note and fixed-rate mortgages are higher now than where they were in late January. This could add to pain in the housing market...or be cause for optimism. It depends on who you ask.

Sign of 'robust' growth ahead?

The yield on the 10-year, which fell as low as 3.28% in intra-day trading the day after the Fed's emergency cut in January, went as high as 3.96% during trading Wednesday before pulling back following the release of a gloomier economic forecast from the Fed. The yield is now hovering around 3.8%

To put that in perspective, bond yields rose more in one month while the Fed was cutting rates than they did during the two years that the Fed boosted rates by 4.25 percentage points.

Meanwhile, Freddie Mac's weekly survey of mortgage rates show fixed-rate loans have climbed more than a half- point from the first survey after the Fed's emergency cut to the most recent reading.

Keith Gumbinger, vice president of mortgage tracking service HSH, says the rise in longer-term rates is not an unexpected or even an entirely unwanted phenomenon. After all, a yield of under 4% for the 10-Year is still historically low.

In addition, some believe that the Fed's rate cuts and the $170 billion economic stimulus package passed by Congress will, if not prevent a recession, keep one relatively short.

"I think the smarter folks in the bond market are starting to realize that economic growth in the second half of the year will be surprisingly robust," said Mark Vitner, senior economist at Wachovia.

Cuts lifting inflation fears...and mortgage rates

But Kevin Giddis, managing director of fixed income at Morgan Keegan, said the rise in long-term yields could also be a sign that bond investors are worried the Fed will go too far with rate cuts and that this could lead to more inflation in 2009.

The European Central Bank has yet to follow Bernanke & Co. with rate cuts of its own and the magnitude of cuts by the Bank of England have trailed the Fed's easing.

The Fed's aggressiveness compared to other central banks is also feeding inflation fears since it is cutting into the value of the dollar. The weaker dollar makes U.S. investments, such as bonds, less attractive to overseas investors.

During the "conundrum" days of 2004 and 2005, Greenspan and other economists suggested it was the attractiveness of U.S. bonds and other assets to foreign investors that helped keep bond prices high and long-term yields low. (Bond prices and yields move in opposite directions.)

If foreign investors pull out of longer-term Treasury bonds and yields keep rising, that could lead to higher fixed-mortgage rates, which could further prolong the weakness in the housing market.

To be sure, Gumbinger said another factor behind the rise in fixed mortgage rates is the economic stimulus bill, which lifted limits on the size of the home loans that could be bought and insured by government-sponsored mortgage finance firms Fannie Mae (FNM) and Freddie Mac (FRE, Fortune 500).

That temporary rise in the limits of what are known as conforming loans was done to get mortgage financing flowing again in regions of the country with high home values.

But Gumbinger said it also introduced doubts into the one part of the mortgage market that had been functioning without problems since the meltdown in the market for mortgage-backed securities last summer.

The debate continues

The lower fed funds rate has resulted in a cut in the prime rate that banks charge many of their better business customers, as well as some consumer loan rates, such as those on home equity lines of credit.

And the widening gap between short-term rates and long-term rates does help improve the profitability of making longer-term loans, giving banks an incentive to lend money to businesses and home buyers even if they are now having trouble bundling the loans into securities.

But the rising long-term rates are a sign that there are no easy answers as the Fed and Congress struggle to keep the economy from falling into recession. Volatile market reaction to the Fed's moves is proof that investors aren't sure where the economy is heading.

Giddis said there is likely to be more volatility in the bond market during the next four weeks leading up to the Fed's next meeting on March 18, as the debate continues between those who believe the economy has already toppled into recession versus those who think these cuts are an overreaction that will fan inflation.

"What happens with rates between now and then depends on the data we get in between," he said. "The numbers become really, really important." To top of page

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