More important, fear is creeping back into the bond market. Until recently bond players shrank from nothing -- not strong economic growth, not energy-driven inflation, not even the Fed's hikes in short-term rates totaling more than 3 percentage points heading into 2006. In the past a set of factors like that would have made bond investors run for cover. They would have demanded much higher yields to take on the greater risk of holding a fixed-income security for such a long period. This time long-term rates stayed unusually low, prompting former Fed Chairman Alan Greenspan to dub the phenomenon a "conundrum."
Now the mystery is starting to clear up. Bond investors sense that there is more risk in holding bonds than they had previously thought. Their unusually low assessment of risk in recent years has been a key factor holding bond yields down. The question has been whether that ease in risk perceptions signified a lasting or temporary change in the way investors view the market. The recent sell-off suggests that at least some of the shift was temporary. If investors are rethinking bonds' riskiness, then yields could travel even higher in coming months.
The bond market's adjustment also raises the stakes on future rate decisions by the Fed, since it could have significant implications for the outlook. In particular, higher yields will lift mortgage rates further at a delicate time for housing. The average 30-year fixed mortgage rate is already up to 6.5%, the highest in almost four years, and housing is weakening. In that sense, higher bond yields may help slow the economy, thereby reducing the need for the Fed to hike short-term rates.THE NEW FEAR FACTOR in the bond market is not just the chance that higher inflation down the road could eat into the return on bonds. In fact, in recent weeks measures of inflation expectations have not moved up very much. Most of the increase in bond yields has been caused by higher real yields, which represent the noninflationary costs investors perceive in locking up their money over a given period of time. That distinction is important, since it was a lower assessment of risk that had helped to push down real bond yields -- and thus overall yields -- during the year or so after the Fed began raising short-term rates. The rebound in real yields implies that some of the earlier downshift in risk perceptions is reversing.A comparison of 10-year yields on Treasuries and 10-year Treasury Inflation Protected Securities (TIPS) illustrates what's happening (chart). First of all, note that the market yield on a regular Treasury note comprises both a real yield and an expected rate of inflation. The yield on the TIPS, however, is a real one that investors earn apart from the premium they get if inflation rises. One way to gauge inflation expectations, then, is to look at the difference between the regular market yield and the TIPS yield. This exercise shows that more than two-thirds of the increase in the 10-year yield since Jan. 18 reflects a rise in the real yield. Only a third is caused by higher expected inflation.THE ANALYSIS SUGGESTS that investors are reevaluating risks other than those for inflation. For one thing, Fed policy is much more uncertain. Until recently the Fed clearly signaled to the markets that it would raise its target rate in a series of measured hikes. Now, Fed decisions will turn almost totally on what the ups and downs in the data say about the strength of the economy and inflation, a fact that will also make the market more volatile in response to economic reports and other news.
New risks also are emerging from changing global conditions. Prospects for stronger growth and tighter monetary policy overseas are sopping up excess global liquidity, which had helped to keep bond yields low. These new global influences also put the dollar at risk. Less liquidity and more attractive investment opportunities outside the U.S. could make it trickier for the U.S. to finance its huge current account deficit at today's level of the dollar.
If the bond market's evaluation of risk in the credit markets has, in fact, been excessively low, that would have implications for Fed policy. Financial conditions may well have been too stimulative over the past couple of years, implying that a greater degree of Fed policy tightening might be needed. Fed Chairman Ben S. Bernanke alluded to that possibility in his Mar. 20 speech on bond yields.
Already, the financial markets are anticipating that the Fed will lift its target rate to 5% at its May 10 meeting. The futures markets are beginning to bet on yet another hike after that. A few months ago only a scant number of market players expected the rate to go that high.BUT IF THE ECONOMY CONTINUES to percolate partly because of past highly stimulative financial conditions, the Fed may have no choice. Its key concern now is high "resource utilization," meaning strong demand is putting pressure on labor markets and production facilities that could generate inflation. By those lights, the Fed saw no comfort in the the March employment report.
Labor markets continued to tighten last month as payrolls increased by 211,000 workers and the jobless rate fell back to 4.7%, matching the January rate as the lowest level since July, 2001. Earlier this year the Fed predicted that the unemployment rate would end the year in the range of 4.75% to 5%. That now seems unlikely.An average pace of about 175,000 jobs per month over the past year has caused the unemployment rate to decline by 0.4 percentage points. If that rate of payroll gains continues, the jobless rate would end up close to 4.4%. That level would most likely fuel wage growth in excess of productivity gains and threaten to lift inflation. That's especially true in the service industries, which employ 80% of all private-sector workers. The service sector has accounted for all of the recent acceleration in wage growth.
One worrisome implication of any past underevaluation of risk by the bond market has to do with housing. Over the past couple of years, mortgage rates, which track the movements in 10-year Treasury yields, might well have been lower than they otherwise would have been if Treasury yields had been higher. Low rates may have helped to pump up housing demand. The higher rates go, the greater the danger of a big correction in housing activity and home prices.
As the bond market's new respect for the risks in the outlook push up long-term rates, the Fed will have to walk a fine line as it decides how high to lift short-term rates. By James C. Cooper