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Tuning out Greenspan
Bond investors aren't as worried about oil prices as the Fed is. Are they right...or in denial?
April 11, 2005: 1:14 PM EDT
By Paul R. La Monica, CNN/Money senior writer
Long-term rates have surged lately but are still below last summer's levels...even though the Fed has raised interest rates seven times.
Long-term rates have surged lately but are still below last summer's levels...even though the Fed has raised interest rates seven times.

NEW YORK (CNN/Money) - Federal Reserve chairman Alan Greenspan called it a "conundrum." Chicago Fed president Michael Moskow deemed it a "puzzle."

So it probably won't be long before another Fed member trots out the Winston Churchill quote about Russia and says that relatively low long-term rates are "a riddle wrapped in a mystery inside of an enigma."

The yield on the 10-year Treasury now stands at 4.46 percent. And even though that's significantly higher than two months ago, when the yield was briefly below 4 percent, long-term rates are still lower than where they were before the Fed started raising interest rates last year.

Back on June 29 -- the day before the Fed's first interest rate hike -- the yield on the 10-year Treasury was 4.7 percent. Since bond yields move in the opposite direction of bond prices, this indicates that there are still a fair number of investors interested in buying bonds.

Typically, longer-term rates move in the same direction as short-term interest rates, if not necessarily in lockstep fashion. So how is it that long-term rates are lower than they were last summer even though short-term rates have shot up from 1 percent to 2.75 percent?

Bond market to Fed: Wake us when the job market improves

Simply put, fixed-income investors don't appear to be buying the Fed's concerns about inflation heating up. Sure, oil prices are near record highs and the prices of other commodities such as copper and cement have also surged. But some say what's missing from the equation is the classic telltale sign of inflation: increased wages and a strong job market.

After a better-than-expected employment report for February, the number of new jobs added in March was much lower than economists had anticipated.

"The bond market is far less sanguine about the economy than the Fed is. They are essentially saying we don't see that much strength," said Barry Ritholtz, chief market strategist with Maxim Group.

To that end, Ritholtz said he doesn't think bond investors will worry about inflation until there are several months in a row with at least 250,000 jobs being added to payrolls.

In addition, the recent rise in crude doesn't appear to have bond investors worried because if anything, persistently high oil prices could have a dampening effect on the economy going forward, which would further minimize the threat of inflation.

"Concerns about inflation are well tempered by concerns about how quickly economic growth will be undermined by rising rates against a background of continued high energy prices," said Louise Purtle, chief strategist with CreditSights, a fixed-income research firm. "When the evidence of that appears in the numbers, the bond market's low long-end yields will look justified."

In other words, bond investors expect the Fed to keep a lid on inflation and don't believe the Fed will have to aggressively raise rates in order to do so. For this reason, most market observers still believe that the Fed will increase rates by another quarter-point at its next meeting in May. Such a move would bring the federal funds rate up to 3 percent.

Investors waiting for an oil slick

Still, it's not as if the bond market is completely ignoring the threat of inflation. Longer-term rates have moved sharply higher in recent weeks, partly because of Greenspan's "conundrum" comments and because of the spike in energy prices.

"The inflation issue is creeping into the bond market and that's why rates have moved up over the past six weeks. Investors didn't consider it a problem a couple of months ago," said Margo Cook, head of the fixed income division at BNY Asset Management, the investment arm of the Bank of New York.

Cook thinks that even if the Fed keeps raising rates, bond yields won't head much higher. She argues that the 10-year is now fairly valued based on current inflation expectations.

At worst, she says the yield on the 10-year could head as high as 5 percent by the end of the year if businesses start passing off the cost of high oil prices onto consumers.

The market will be looking for evidence of that in the next consumer price index (CPI) report, which measures the cost of consumer goods. The CPI for February rose at a higher-than-expected rate, spooking some investors.

The next CPI report, for the month of March, is due to be released on April 20. Economists are predicting a 0.4 percent increase in the overall CPI number and a 0.2 percent increase in the "core" CPI, which excludes food and energy prices.

If consumer prices don't rise dramatically, Cook says the yield on the 10-year could fall as low as 4.25 percent...even if the federal funds rate is somewhere around 4 percent by the end of the year, as many investors expect it to be.

Maxim's Ritholtz agrees that bond investors are still more worried about the economy slowing down than overheating. So with that in mind, he also thinks bonds could continue to rally, which would keep the yield on the 10-year relatively low.

"You can't fight the bond market. There's only so much the Fed can do," said Ritholtz. "If investors are more concerned about economic growth slowing down in the future than inflation, they will flock to bonds."

But not everyone thinks the bond market is right. There are some concerns that fixed-income investors are missing the boat regarding inflation...and that's the reason why some Fed members have been harping about long-term rates being low.

"The bond market is still behind the inflation curve," said Jack Ablin, chief investment officer with Harris Private Bank. "The inflation story continues to chip away at our economy and it doesn't seem to be getting any weaker."

For this reason, Ablin thinks bonds are not a safe investment right now since he thinks long-term rates will eventually have to head higher. "Inflation is probably inclined to get worse on a gradual basis," he said.

For CNN/Money's special report about rising oil and gas prices, click here.

For more about the job market, click here.  Top of page


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