The game changed on Tuesday. Midway through a Greenspan snoozer to Congress, describing the condition of the nation’s banks, this line: “The banking sector is well-prepared for higher interest rates….”
When Greenspan gives us one of these world-changers, in knowledge that he is inducing a bond-market wreck, his delivery is always the same: complete, blinking-through-Coke-bottles innocence. A wreck it was. Bond prices fell, and the 10-year T-note yield leaped almost to 4.5 percent for the first time since last fall. Mortgages rose to 6 percent, but our worst day was today, up to 6.125 percent.
Is this rate rise an overreaction?
We knew three weeks ago that the job market had shifted gears, and then got revisions of 1st quarter 2004 inflation measures from sub-1 percent to almost 1.5 percent. This week brought more confirmation of a March sea-change: orders for durable goods doubled the forecast, rising 3.8 percent, and the Fed’s “beige book” described a nationwide up-shift in growth. GDP growth in the 1st quarter may have been in excess of 5.5 percent.
There is nothing dangerous – inflationary – in this rapid growth, nothing that would cause the Fed to try to slow the economy. However, the Fed’s reflation campaign has concluded. The chairman: “Threats of deflation, which were a significant concern last year, by all indications are no longer an issue before us. But clearly it is a change that has occurred in the last number of weeks.”
The Fed has no need to lean into the economy, but it does need to begin to remove the extreme ease that has produced this rate of growth. Only two things give the Fed any pause at all: as The Man said, this economic trend change is less than two months old, its durability unknown; and second, although the numbers of new jobs are increasing, wages are not.
Two more Fed-heads this week emphasized that the Fed would still be “accommodative” even if it began to raise the overnight cost of money from a deflation-fighting 1 percent to a “neutral” level. In monetary terms, true, but in bond market terms…upward-tilting chaos.
As the Fed begins to raise its rate, it will quickly extinguish the ardor of speculators for the “carry trade,” borrowing at overnight cost to buy bonds, hoping the big spread will offset the risk to bond values in a general rate rise. As fears of Fed increases beyond the two, .25 percent hikes now priced into the market grow, a question already on the table will rise in volume: where is “neutral,” exactly?
The Fed isn’t saying. The ablest Fed-watcher talking for the record, PIMCO’s Paul McCulley, has argued for six months that neutral is no higher than 2.5 percent in this excess-capacity, price-stable new world. Outgoing San Francisco Fed president Parry amused himself by throwing a stink bomb at traders, saying he thought that neutral lies “…between 3.5 percent and 5.5 percent.” Fed governor Ben Bernanke this week continued his argument for an inflation peg for Fed funds, clearly feeling no urgency to raise the rate on anything, but equally clear in his tired tone and sure knowledge that so long as Greenspan is running the shop there will be no formulaic peg of the Fed funds rate to anything, and it will rise when it should.
Greenspan has always argued that he wants maximum flexibility to react to inherently unpredictable risks. Letting the Fed funds rate languish near absolute zero leaves the Fed none of the maneuvering room that a return to neutral would provide. A last hint from his two days of Congressional testimony this week: he did not once use the code word “patient,” and not one Congressperson had the chutzpah to ask.
Look for volatility – not just straight up – as the bond market struggles to figure out when the Fed will begin the search for neutral, and where it might be found.
Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at email@example.com.
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