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Minyan Mailbag: Fed Conundrum

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Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this exchange between two worthy Minyans with that very intent.



Prof. Reamer,

I have been following your recent commentary on interest rates and wonder a bit why you see the Fed cutting rates soon. Other than low yields on the long end I don't really see much evidence for an economic slowdown. I don't see Greenspan's comments today as any different than the Bernanke comments in '02. The bond market often doubts the control of the Fed but historically the Fed has always won. Maybe this time is different but it seems like the odds favor betting with the Fed rather than against them.

In June of '03 you wrote "... 80% (roughly) of bond bear markets start immediately before or immediately after the Fed increases the Fed funds target rate." Isn't that basically what Greenspan is talking about when he calls the current bond yields a conundrum?

On a final note, the "conundrum" really seems focused on the 10 and 30-yr yields while the 5-yr bond has moved higher with short rates. Doesn't that seem to point towards some sort of structural or technical factor moving the long-end rather than a sharp change in Fed policy in the near future?

Minyan Mike

Mike,

I'll go thru each of your points in order and see if I can explain...

"I have been following your recent commentary on interest rates and wonder a bit why you see the Fed cutting rates soon."

Answer: b/c the Fed follows the bond market, it does not lead it. And rates are, and have been for some time, going down. Any analysis of Fed funds vs yields (at any maturity) over the last 20, 30, 40, 50 years will show that the actual bond market - at ALL yields - moves in the direction first that the Fed eventually follows. The price record is incontrovertible on this point. Usually the Fed moves within 3 months once the bond market moves. Only 2 times in the last 25 yrs has it taken longer to than 3 months to do what the bond market was doing. 2000 and now.

"Other than low yields on the long end I don't really see much evidence for an economic slowdown."

Answer: Of course you don't, for the same reason. Markets LEAD other measures of economic activity like GDP, employment, industrial production, retail sales, etc. None - not one - of the big changes in economic activity for this past century were "predicted" by macro stats. It is useless, except in a confirmatory sense, to look at macro stats to help predict the course of the economy.

"I don't see Greenspan's comments today as any different than the Bernanke comments in '02."

Answer: True. They are politicians, not economists. You could expect to discern some differences of opinion among economists, but not politicians. They stay 'on message', and for good reason (that reason being self-preservation).

"The bond market often doubts the control of the Fed but historically the Fed has always won. Maybe this time is different but it seems like the odds favor betting with the Fed rather than against them."

Answer: Again, the bond market moves first and the Fed follows. As for betting with the Fed, many have done so and made lots of money doing it. But only at the expense of others not so fortunate to be the first in line to receive the Fed's free money. Think Goldman and Morgan benefiting at the cost of pensioners and laborers and you'll understand the dynamic at work.

"In June of '03 you wrote "... 80% (roughly) of bond bear markets start immediately before or immediately after the Fed increases the Fed funds target rate." Isn't that basically what Greenspan is talking about when he calls the current bond yields a conundrum?"

Answer: And 20% (roughly) don't.

"On a final note, the "conundrum" really seems focused on the 10 and 30-yr yields while the 5-yr bond has moved higher with short rates. Doesn't that seem to point towards some sort of structural or technical factor moving the long-end rather than a sharp change in Fed policy in the near future?"

Answer: 10s and 30s are a massively important part of the curve. You cannot dismiss what is happening 'out there' b/c short rates are doing something different. What the different dynamics of the short and long end points to, in the conventional sense, is simple: a weakening economy. 100% of the time the yield curve has inverted for more than 60 days, there has been a recession in the U.S. 100% of the time. What is happening up and down the yield curve has nothing to do with the Fed. As I noted above, and I cannot overstate this, the Fed FOLLOWS the bond market in its policies. What is happening to the yield curve tells us what the Fed is GOING to do with its policy in the future. And on that score I stand firmly by my prediction that the Fed is going to lower rates in 2005. I have a bet outstanding with John Succo that it is before the end of June. We'll see.

Yours,
S

No positions in stocks mentioned.

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