The Fed raised interest rates for the 12th time yesterday, pushing Fed funds up another 25 basis points to 4.0%. Now what? More of the same, of course.
The central bank assured the world that “that policy accommodation can be removed at a pace that is likely to be measured.” That’s central banking-speak for: 25-basis points for as far as the eye can see remains the mantra for monetary policy, much as it’s been since the tightening began in June 2004.
But while the Fed continues to tighten like clockwork, the bond market’s confidence is in question. The 10-year Treasury yield rose a bit yesterday, ending the session at roughly 4.58%, near the highest levels since March.
The Fed’s persistent, if cautious effort to tighten the monetary strings seems finally to have taken root in the hearts and minds of the fixed-income set. Indeed, the 10-year’s yield is up nearly 60 basis points since the end of August.
Yet while the 10-year’s yield is up sharply since August 31, the all-important “spread,” or rate differential between the two- and ten-year Treasuries hasn’t changed all that much, and in fact has slipped ever so slightly in the past two months. At August’s close, the spread was 18 basis points; as of yesterday, it had inched lower to 16 basis points, according to Treasury Department data.
So much for the time value of money. The lack of a significant premium for locking up principal for ten years as opposed to two is part and parcel of a flat, or near-flat yield curve. What does the perseverance of a flat world order in yield curves say about the Fed’s war to convince the bond market that inflation is under control? Clearly, the bond market is convinced.
But how does one square that with the fact that the central bank, by its own testimony, remains “accommodative,” a description that’s supported by the usual array of numbers. Consumer prices advanced by 4.7% in the year through September, a pace that’s higher than both the current yields on the 10-year Treasury Note and Fed funds. In other words, the real (or inflation-adjusted) yields are negative, which is to say, accommodative.
How long will the bond market live comfortably with a flat yield curve and negative real rates? For an answer, keep on eye on the next batch of economic data. An economy that continues to surprise on the side of growth will add to the pressure on the bond market to reprice inflation risk.
The bond bulls have in fact been pummeled of late, but their cause is hardly hopeless. Indeed, recent economic data has been of two minds, alternatively supporting predictions of a slowdown and continued growth. Yesterday’s factory orders report for September fed the fears of the slowdown school of thought. But then the October ISM Report on Business offered a bit more optimism that the economic expansion still had a head of steam. Although the so-called PMI index that tracks the manufacturing economy slipped a bit in October, falling to 59.1 from 59.4 previously, it was still far above the critical 50 mark (a reading below 50 indicates a contracting state of manufacturing activity; above 50 points to growth). Long gone is the reading of 51.4 logged back in May that raised the specter of recession.
“The U.S. economy is in good shape which is why the Fed is going to have to keep raising rates,” Graham McDevitt, global head of government bond strategy at ABN Amro Holding NV in London, tells Bloomberg News today. “Yields will keep pushing higher.”
Of course, higher rates may be just what the markets want, to judge by the fairly stable two/ten-year spread. A further rationalizing for staying bullish on bonds stems from the argument that higher rates will tone down any emerging inflation. One could argue that the bond market looks inclined to be bullish no matter what the Fed does, and thereby risks a correction of major magnitude at some point. Yet for the moment, even the gold market is looking less anxious of late, with an ounce of the metal changing hands for about $460, down $20 from the highs of October.
In fact, the bond market can take heart in the realization that the Fed yesterday effectively announced that it would keep raising interest rates until the economy slowed. And with Fed funds futures contract for next May currently priced at 4.725%, that’s a threat that some are taking seriously.