Fed Chairman Ben Bernanke’s at war with the bond market, and himself.
Yesterday’s 25-basis-point hike in the Fed funds rate was the 15th in a row for the central bank, and the first for Bernanke, who took over from his predecessor, Alan Greenspan, on January 31. Judging by the FOMC statement that accompanied Tuesday’s rate hike, more rate hikes may be coming: “The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance.”
Traders in the Fed funds futures market responded immediately, repricing the May contract a bit in anticipation of another 25-basis-point hike, which would bring Fed funds to 5.0% when the FOMC meets next on May 10.
Traders in the bond market followed suit, selling the 10-year Treasury with a vengeance, and thereby boosting the yield yesterday to around 4.78%, or up by nearly 8 basis points over Monday’s close. In fact, as we write, the selling continues, pushing the 10-year yield to 4.80%, which is approaching the highest levels in almost two years.

But for all the selling going in fixed-income lately, the yield curve remains flat, which means it could invert quickly and without warning. And as the last few years show, the bond market has embraced selling only to return to form and argue in favor of lower rates.
In our view, Bernanke wants the market to blink for more than a week or two this time, if only to announce his intent to dominate monetary policy. Filling Greenspan’s shoes is tough, and nowhere more so than when it comes to convincing Mr. Market to follow the Fed’s script. Greenspan himself had some trouble in that regard, with bond yields staying lower than he thought prudent. Such is life in the 21st century.
Or, to use Bernanke’s observation, there’s a global savings glut in the world, and that’s keeping long rates artificially low. Perhaps, but if you accept his line of thinking then it follows that artificially long rates, if left untouched, will eventually redirect capital in ways that financial prudence might otherwise reject and thereby boost inflation to higher levels than is tolerable. All of which leads the Fed to focus on the real estate market, and take actions that slow the passion for property, which may be convincing Joe Sixpack to borrow and spend above and beyond levels the Fed deems appropriate at this juncture.
In fact, there are signs that the housing market may be cooling–last week’s sharp drop in new home sales being the latest smoking gun. Then again, Bernanke still has his work cut out for him, if one measures the still-buoyant state of housing sentiment by the much larger sample drawn from existing home sales. What’s more, consumers are growing more optimistic, or so the Conference Board tells us. Modifying such momentum may take another rate hike or two.
Indeed, Bernanke desperately needs to show Wall Street and Main Street that he’s in charge, and that the markets respond when he acts. The jury’s still out, but whatever the final outcome the front line on gauging results will be the 10-year Treasury yield, which carries no small influence over mortgage rates, which in turn casts a long shadow over the real estate market.
For the moment, the yield curve remains more or less flat. In relative terms, that means that borrowing money is still attractive, perhaps too attractive for Bernanke. The bond market in the last 24 hours has shown a willingness to revise its long-standing position that central banks can’t push traders around like they used to. Indeed, Bernanke has admitted as much in the past, a la his global savings glut argument.
But now Bernanke must effectively dismiss his own argument over worldwide liquidity, or at least convince bond traders to dismiss it. The central bank still matters, Ben is saying. Eventually, the bond market will listen. But when, and at what price? Will a 5.0% Fed funds do the trick? 5.25%, or even higher? Must Ben bring the economy the precipice of recession to make his point? Will he? Or will the Fed chief blink first?
© 2006 by James Picerno. All rights reserved.