Fed actions not boosting bond yields
By Rachel Beck
Associated Press
NEW YORK — The way the bond market has been acting lately makes it seem as though investors there completely disagree with the Federal Reserve's optimistic outlook for the economy.
When the Fed raised interest rates last month for the third time this year in a move to keep the economy's growth in check and stem inflationary pressures, bond yields tumbled — something rarely seen since those two things often move in lockstep.
But this may be a case where looks could be deceiving. In fact, bond investors could even be cheering the Fed's moves.
The bond market tallied its fourth year of gains in 2003, with yields on the 10-year Treasury note — which move in the opposite direction to prices — falling to 45-year lows. That rally was expected to end this year as strength in the economy and the stock market would make government bonds less attractive to investors.
At points over the last year, it looked as though that pullback was happening, but it never lasted for long. Bonds instead have spent much of this year seesawing — rising and falling as the prospects for the economy changed.
And since the yield on the 10-year note peaked at 4.87 percent in June, it has been falling. It dipped below 4 percent in early September and again last week.
At the same time, the Fed has shifted to a tightening interest-rate policy, boosting its target for the federal funds rate — the rates banks charge each other on overnight loans — by a quarter percentage point three times since June. The funds rate, which now stands at 1.75 percent, is the Fed's primary tool for influencing economic activity.
That disconnect is unusual. Consider that in 1994, the 10-year Treasury yields increased by roughly 2 percentage points as the Fed raised short-term rates. But the yield is actually down nearly 30 basis points for all of 2004 and has fallen almost 90 basis points from its peak, according to data from Citigroup Inc.'s Smith Barney division.
Many market-watchers say bond investors' actions are being driven by the fact that they are taking a more pessimistic view of the economy than the Fed.
But there could be more to this story. Some on Wall Street think that bond investors may be lauding the Fed on its good job controlling inflation.
For investors, the real question ahead is whether this bond-market rally has staying power. Should inflation stay so low, then maybe it has a chance. But anything to counter that or a surprising surge of economic strength could throw it off this path.
John Caldwell, chief investment strategist at McDonald Financial Group, warns that at any moment the market could change its course. He points to what happened a decade ago, when the 10-year yield shot up over the course of a year from 5.43 percent to nearly 8 percent — almost a 50 percent increase.
Still, some investors may not be ready to write off bonds just yet. The market has shown in the last year that its next move and what fuels it could be anyone's guess.
