What Bonds Are Saying

June 13, 2003 -- Friday the 13th -- will likely go down in the record books as the frothy top of one of the biggest bond market bubbles in modern American finance. In the weeks since, the abrupt sell-off in government bonds has caused interest rates to shoot up a full percentage point to above 4% on 10-year Treasury notes. "We saw the generational low," says David R. Kotok, president of Cumberland Advisors Inc., a money manager in Vineland, N.J.

So far, the rise in rates isn't too worrisome because it appears to reflect a receding fear of deflation and growing confidence about the strength of the economy and the demand for loans. With economists scrambling to raise 2004 forecasts for GDP growth -- Goldman, Sachs & Co., for example, has upped its projection to 3.3%, nearly a percentage point more than as recently as June -- it's only natural that rates would rise.

Still, there are potential dangers ahead. Even with the recent sell-off, today's interest rates still reflect an assumption that inflation will remain very low and perhaps even drop a bit more. But the massive fiscal and monetary stimulus pumped into the economy is likely to rekindle inflation down the road and increase the supply of bonds. So rates are likely to move higher: Kotok predicts that the 10-year Treasury will be trading at yields of 5.5% to 6% within two years, up from the 45-year low of 3.11% in June.

If rates rise because the market begins to see inflation as a bigger risk than deflation, that could slow the recovery -- particularly if mortgage refinancing screeches to a halt. "There's legitimate nervousness about whether this rate runup is going to temper the coming recovery," says Douglas G. Duncan, chief economist at the Mortgage Bankers Assn. Worse, rates could overshoot on the way up because of technical factors and changing sentiment, just as they overshot on the way down.

Policymakers at the Federal Reserve are somewhat surprised by the recent runup in rates since they think inflation remains well under control. In a July 23 speech in La Jolla, Calif., Fed Governor Ben S. Bernanke forcefully set out the Fed's view that the risks of a further fall in inflation outweigh those of resurging inflation. He noted that the Fed's favorite inflation barometer -- which tracks personal consumption expenditures, minus food and energy -- might fall a half-point more, to roughly 0.7% by the end of 2004. That's because Bernanke believes that even 4% annual growth wouldn't be enough to soak up all the excess production capacity that still exists in the economy.

But the credit markets seem to be tuning out the Fed and its deflation warnings: The yield on 10-year notes fell just one-hundredth of a percent, to 4.11%, the day of Bernanke's speech. "The Fed has gone from being perceived as all-powerful to being viewed skeptically," says Louis Crandall, chief economist at Wrightson ICAP LLC.

Instead, the market's attention is slowly swinging toward early signs that inflation may not be dead after all. While broad measures such as the producer price index and the consumer price index aren't accelerating, producer prices for intermediate-stage materials, minus food and energy, have been rising at an annual rate of better than 2% this year. That's a sharp contrast with the first half of 2002, when they were falling over 1% a year. Those fears could be exacerbated if foreign investors decide that inflation risks eroding the value of their U.S. investments. In the 12 months through May, foreigners added $620 billion to their holdings of U.S. Treasury, agency, and corporate bonds. If they were to sell off in a big way, it would push down the dollar, raising import prices and feeding inflation.

Inflation could also rise because of the sheer amount of money being pumped out by the Fed. Growth in the money supply is up by about 7% annually over the past 21/2 years -- more than double economic growth. That means more money is chasing goods, says David L. Littman, chief economist at Detroit-based Comerica Bank: "You can't increase money at these rates and expect inflation not to accelerate."

Another reason to expect higher prices is that the Fed wants modestly higher inflation to grease the wheels of commerce. Fed policymakers have been spooked by the brush with deflation and realize they let inflation get too low, says Brandeis University economist Stephen G. Cecchetti, former research director for the Federal Reserve Bank of New York. "If you polled the members of the FOMC today," he says, "I bet they'd say they want the CPI at 2% to 3%, whereas a few years ago they would have said 1% to 2%."

Whether or not inflation expectations are the culprit, the rise in rates spells frustration for borrowers who missed their chance to lock in rates at the bottom. And it's painful for investors who bought bonds at the market's peak, thinking they were a safer bet than stocks. Already, the price of the 10-year note has fallen 9% since June 13. If the yield on the benchmark note rises an additional point, as many expect, prices will fall 7% more.

The most dramatic impact of rising rates will be the crimping of Americans' ability to turn their housing wealth into cash. Goldman estimates that "mortgage equity withdrawal" -- including refinancing and home-equity borrowing -- has added spending power equal to about 4% of disposable income. But refi activity has already slowed a bit. And Goldman economist Edward F. McKelvey predicts that if rates stay at current levels or rise, the drop-off in spendable funds from mortgage-equity withdrawal could slash as much as a point from growth in the coming year.

So far, the stock market is shaking off higher rates. "Yields aren't high enough yet to provide much competition to stocks," says Tom McManus, chief strategist at Banc of America Securities LLC. McManus is steering clients toward stocks that will benefit from a recovery and be relatively immune to rising rates, such as food and beverage companies. Higher inflation, which slams bonds, isn't always bad for stocks. By giving companies more pricing power, "the resurgence of inflation is a good sign for the stock market," argues Brian G. Belski, a market strategist at U.S. Bancorp Piper Jaffray (USB)

Fed Chairman Alan Greenspan and his central bank colleagues would like rates to stay low until the economy is growing briskly. But there's not much they can do about it. True, Greenspan & Co. managed to talk longer-term rates lower this spring when they hinted that the central bank might buy bonds to keep deflation at bay. But the rally soon reversed itself when Greenspan made clear that was only a last-ditch option -- a point that Bernanke echoed on July 23. Fed officials are now saying that the higher rates reflect an improvement in economic fundamentals.

Market experts worry that a big reason for the spike in 10-year Treasury yields is that hedging-related selling is feeding on itself. Fannie Mae (FNM) Freddie Mac (FRE), and others have been selling Treasuries to offset the impact of rising rates on their portfolios of mortgage-backed securities. But that causes market rates to rise -- which forces them to sell even more.

Massive debt issuance. Rising growth. Early inflation signs. It's not surprising that rates are rising. It's surprising they ever got so low in the first place. By Peter Coy in New York, with Rich Miller in Washington, Marcia Vickers in New York, and Joseph Weber in Chicago

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