All talk and no action - how the US bond market rodeo broke away from the Fed
Charlotte Denny Monday August 11, 2003 The Guardian Faced with the harsh reality of cutting the deficit to please the markets, one aide in the Clinton White House is reported to have said that if he could be reborn, he'd come back as the bond market. "Then I could intimidate everybody." After the turmoil in the bond markets over the past two weeks, Alan Greenspan must be wondering if he should chuck in his day job and get a job in the bond markets as well. The market's two-decade long bull run has finally ended, and with it Mr Greenspan's carefully crafted strategy of keeping long-term interest rates on government debt (which move in the opposite direction to prices) low to prop up the economy. In the early spring when the build up to war had driven the world's largest economy into what Mr Greenspan called a "soft spot", the Fed embarked upon a deliberate strategy of talking down long-term borrowing costs. Members of the Fed's open markets committee (FOMC) talked about radical solutions like pumping money directly into the economy by buying bonds. After its May meeting, the Fed made history when it noted that one of the risks was that inflation could go too low. Even though the FOMC left borrowing costs unchanged, the markets decided that with central bankers openly talking about deflation, there was no risk that their returns would be eroded by rising prices. They snapped up more long-term debt, pushing down yields even further, giving the economy a boost without the Fed even having to cut short term borrowing costs. By mid-June, yields on 10-year treasury bills had reached 3.1%, their lowest since the late 50s. Encouraged by bargain deals, US households rushed to remortgage their homes. As in Britain, consumers took the opportunity to extract some of the equity out of their homes, switching to larger but cheaper mortgages, and then spent the proceeds - sometimes paying off more expensive credit card debt, but more often in America's malls and car showrooms, keeping the economy ticking over at a time when business was still too nervous to start investing. But the party ended abruptly in late June when the Fed surprised the mar kets with a smaller than expected borrowing cut - just 25 basis points - and played down the chances that it might have to resort to unorthodox techniques such as buying long-term bonds to keep the economy afloat. Long-term yields have risen by 1% since mid-June, back to more normal levels, but pushing the rate on a 15-year mortgage up from about 4.5% to more than 6%. Unsurprisingly, remortgaging has collapsed, and with it, some worry, the fledgling US recovery. Stephen Lewis, at Monument Securi ties in London, says there was a fatal flaw at the heart of the Fed's policy. As householders remortgaged, the duration of their loans dropped, forcing the lenders to buy up more long-dated debt to rebalance their portfolios, thus exacerbating the bond bubble. The reverse process occurred when yields started rising, and households cut back on remortgaging. To prevent their portfolios lengthening, players in the mortgage backed market sold bonds, reinforcing the fall in prices and rise in yields. The mortgage-backed market is now one and half times the size of the treasuries market, raising questions about whether risks can be safely laid off on to government debt. Mr Lewis doubts they can. The Fed, he says, has created a "self-destruct" mechanism at the heart of the US financial system. "With cruel precision, such a mechanism could be triggered only when investors begin to feel better about economic prospects." The sharp switch in investors' expectations may also prompt reconsideration about whether the Fed should follow other central banks in adopting an inflation target. Although on paper the Fed is the least transparent of the world's large central banks, in practice it has been the easiest one for markets to predict. Research by Joachim Fels at Morgan Stanley shows that economists polled ahead of central bank meetings have a much better track record at predicting the FOMC than either the European Central Bank governing board, or the Bank of England's monetary policy committee. The reason is that the Fed usually signals its moves in advance through speeches by FOMC members. This time, however, the Fed has seriously wrongfooted the markets to the point where some are wondering what its strategy really is. In the spring it seemed the idea was to keep short-term interest rates low as an insurance against the risk of outright falls in prices, while holding up the possibility that if a Japanese-style deflationary spiral threatened, the Fed would use tactics like buying up bonds to expand the money supply. Since June, however, the markets have simply been confused. The statement following this week's Fed meeting will be all the more closely scrutinised as a result. The bond market appears to have decided that the recovery has arrived. But the FOMC is likely to be more circumspect. Most of the second-quarter rebound in activity was accounted for by government spending, particularly on defence. With US employment falling despite the pick-up in growth, the Fed seems likely to stand by its assessment that the risks to the economy are still on the downside. Some commentators dismiss unemployment as a lagging indicator. If so, it has been lagging for a long time - the US economy moved out of recession in autumn 2001, according to the national bureau of economic research. If the Fed sounds a deliberately downbeat note this week will the bond market listen? Once bitten, twice shy is likely to be the rule. Fooled once by the central bankers' attempts to talk down the long end of the market, buyers are unlikely to rush back. And the FOMC, while worried about the short-term outlook, is upbeat about 2004. The recovery is just around the corner, apparently. In reality, the economy is still precariously dependent on consumers who in turn are up to their eyeballs in debt. Disappointing growth seems a more likely scenario than the rapid bounceback US treasury secretary John Snow was confidently predicting in the spring. If the economy falters again, the Fed has much less room to manoeuvre now that short-term yields are at 1%. With the bond market calling its bluff, talking long-term borrowing rates down is unlikely to work. Perhaps Mr Greenspan may yet show the bond market a trick or two?
