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September 19, 1997
An extraordinary bond rally (including the second-best single day in the 1990's, on Tuesday) took mortgages within a hair of the July 31 low at 7.50%, and 30-year T-bonds into the 6.30's.
The July low lasted a single morning. This one should last a little longer, though there has already been a rebound from the best of the week. The next significant economic news is not due until the first week of October.
We can identify the immediate cause of the bond rally with precision: it started with news that the September CPI rose .2% instead of .3%.
That's it, and that's all. A one-tenth percent "surprise" chopped long term interest rates by .25%.
That's crazy.
Well, yeahŠ it is, but that's the way the market is working right now. The oracles of bonds have talked themselves into believing that Mr. Greenspan will not raise the Fed funds rate until and unless there is overt, clear, and unmistakable evidence of inflation -- no matter how hot the economy may get, nor how tight the job market.
Okay, so far. Mr. Greenspan can be interpreted to have said as much, and his lack of action in the face of a hot economy gives support to the interpretation.
So, if the CPI is weaker than an already weak expectation, all the more reason to believe the Fed won't tighten, and the market has a huge Tuesday.
However.
The Fed funds rate is 5.50%. There is only one way on earth to justify a 6.30% bond yield with a 5.50% Fed funds rate: if you think the Fed is about to ease. It is one thing to believe that the Fed won't tighten in the next few, even several months, and another thing entirely to believe that the Fed is about to ease. Ain't gonna happen.
So why the repeat of the July rally?
My working assumption is that investors (especially institutions, who manage the really big money) find it hard to buy stocks at these prices, and are taking profits in stocks and re-allocating portfolios towards bonds. And, they are joined by some speculative money.
Bill Gross, oracle of PIMCO, and a bigtime bond fund manager, says the only thing he's worried about is rates going lower than his lowest forecast. Some worry.
"Clipper" is a five-star stock fund with a great track record, normally fully invested in large "value" stocks. As of August, its portfolio is suddenly 32% in bonds; and of the remaining 62% held in stocks, 44% (27% of the total fund) is held in financial stocks which trade pretty much like bonds. This respected "stock" fund is now 59% bonds.
The market can poke around here in the sevens for some time, but it's going to take an economic slowdown and the prospect of a Fed easing to do better. Take what we've got.
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