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Since the Fed's 0.5% rate hike on May 16, there has been a lot of debate about whether the presumed inflation that's on the horizon is real or imagined. The June 2 release of higher unemployment numbers -- 4.1% in May, vs. 3.9% the previous month -- has done little to relieve the tension as analysts and investors try to plot the future of the economy and the capital markets.
Theoretically, the bond market should be a good barometer of inflationary expectations, since such concerns are built into the interest that's paid on bonds. The higher the bond market thinks inflation might go, the higher the rates. Just to confuse matters, though, higher rates might only reflect the market's anticipation of Fed moves -- rather than inflation itself. This makes reading the economic tea leaves a maddening exercise: What's raising rates, inflation or the Fed?
There's now fierce disagreement among market mavens about the degree to which inflation is -- and should be -- embedded in bond yields. Depending on your view on that, the same interest rate can be interpreted as bullish or bearish on inflation. What seems clearest is that the bond market, like everyone else, is confused about whether the economy is really overheating -- or just taunting the Fed. Most investors consider uncertainty to be worse than a negative certainty, which means they think it's still too soon to come back into the bond market.
"The bond market is trading a bit schizophrenically right now," says Mike Ryan, senior fixed-income strategist at PaineWebber.
MIXED EVIDENCE.
Analysts estimate that the bond market has assumed future Fed rate hikes of an additional 0.5% to 0.75%. That would boost the Fed funds rate -- the rate the Federal Reserve charges banks for overnight loans -- to 7% or 7.25%, vs. a current 6.5%. While most experts still expect the Fed to raise rates by that much, they aren't so sure any longer that it will happen at the Fed's June meeting. Instead, some expect another 0.5% rate hike at the Fed's subsequent meeting, in August. Traditionally the Fed doesn't tighten the economy any closer to an election than that.
Of course, there are those who believe the Fed has already done its job and shouldn't raise rates further. But the evidence on that point is mixed. "On the one hand, finished-goods prices are up, commodities prices are up, and the labor market is extremely tight," says Ryan. "On the other hand, economic growth may be moderating, and the labor market appears to be loosening.
"Then, of course, there are rallies -- such as last week's 19% jump in the Nasdaq -- that could encourage the Fed to pull back on the economy. The paradox is that the market's view of what constitutes good economic news -- and perversely, these days, that means higher unemployment -- often sparks a rally in stocks. That creates more of the wealth that spurs rocketing economic growth. And since the Fed has growth in its crosshairs, stock rallies make bond traders nervous.
To complicate matters further, the effects of whatever the Fed does won't actually show up in the economy for nine months. If the economy is slowing now, it's the result of what the Fed did last August. Neither Ryan nor any of the other followers of the bond market are willing to rely on one month's uptick in unemployment as evidence of a trend. But in an effort to assess whether the Fed should back off now, analysts will keep their eyes peeled for the government's release of the producer price index on June 9, as well as its revised numbers on unit labor costs and productivity.
"CLOSER TO FINISHED."
Most bond analysts agree that the current rate of productivity growth is unsustainable long term. "The best news is in the rearview mirror," says John Hague, a managing director at California asset manager PIMCO. Fears of a slowdown in productivity coupled with a tight labor market will probably drive the Fed to raise interest rates an additional 0.25%, and probably more, according to most bond analysts. Even so, "there is evidence of a minor psychological shift in the market that the Fed is closer to finished than halfway through its tightening," says Hague.
In the old days, an inverted Treasury yield curve -- where the interest rate on long-term government bonds is lower than that on short-term bonds -- was a predictor that economic tightening was coming to an end and that Fed rates, and then bond rates, would drop in the future. Nowadays, because the government is buying back long-term bonds, the inverted yield curve merely reflects scarcity of 30-year Treasury bonds. Bonds obey the law of supply and demand, just like anything else you can buy. When they're in short supply, their prices rise. When bond prices rise, their yields fall.
With the Treasury yield curve suddenly unreliable, bond mavens now watch something called the swap market yield curve as a proxy. The swap yield curve tracks the return you can get if you swap fixed-rate debt for a floating-rate bond that pays some premium over Treasuries. "Currently the swap curve is about flat, which may be an indication that rates have peaked -- or the tightening cycle is drawing to a close," says PaineWebber's Ryan. Of course, the Fed may continue to raise rates, but the market will already have anticipated those increases and incorporated them into the swap yield curve.
"BIG DEAL."
Pricing bonds based on Fed policy is not the same as pricing for inflation, and bearish analysts such as Stephen Roach, Morgan Stanley Dean Witter's chief economist and director of global analysis, are concerned about the market's apparent disregard for inflationary signals. In comparing the inflation-adjusted and nominal rates of interest on the 10-year Treasury note, Roach found that there was 2.1% implied inflation imbedded in the long-term bond yield. "Given the long-term average of 3.3% inflation in the U.S. economy, this allows for no inflation risk over the next decade," observes Roach. And that implies that bond rates are probably too low to protect investors from inflation.
The rise in the consumer-confidence figures on May 31 came as no surprise to Roach. In his view, the Fed only moved real interest rates into the restrictive zone with its hike two weeks ago. The inflation-adjusted Fed funds rate is now 3.5%. Historically, that rate is 3.1%. Anytime the Fed raises rates above that average it's tightening. But "big deal," quips Roach. "Two weeks of tightening is not going to have an impact on consumer confidence." The Fed won't have finished its job until the Fed funds rate hits 7.5%, declares Roach, who doesn't expect that to occur until next year.
In the meantime, the bond market will teeter on the edge of a buying opportunity, even as analysts divide into two analytical camps. "There's a war between those who think the Fed has done enough and those who think the Fed should tighten more," says William Stevens, senior portfolio manager of Montgomery Asset Management in San Francisco. The former are in the "New Economy" camp, the latter are traditionalists. But both camps believe that bonds could become a hot investment late in 2000 or early in 2001 -- when the Fed finally finishes tightening and bond prices rise as rates stabilize or fall. For now though, it's probably best to wait and watch than to try to read the Fed's mind.
Margaret Popper covers the markets for BW Online
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