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October 24, 2003
The stock market fade has intercepted a rise in mortgage rates, taking us from just over 6.00% to just under.
This improvement is not a change in trend: rate pressure will remain upward in advance of the October economic data to arrive week-after-next, and heavy Treasury borrowing in the week after that. If the economy has switched from job-loss to job-creation, bonds are in trouble -- even if stocks cough up another 500 points.
The Fed meets on Tuesday, and is not likely to do anything harmful or helpful at this time. If its post-meeting statement backs off its references last month to "weakness" in the labor market and concern about disinflation, that would hurt, but I don't think the Fed wants to hurt anything right now.
The Fed had a lousy spring and summer, and its charm offensive in the last sixty days has only begun to repair the damage.
Until this year, Alan Greenspan had been a respected and trusted man in the bond market -- an unusual status for a Fed Chairman, a person who from time to time must hurt bondholders so badly. Since his appointment in 1987, he has waged a consistent and successful war on inflation -- the great long-term enemy of bonds -- and so we understood his tightening in 1987, 1988-90, 1994, and 1999-00. It was painful, but we knew it was the right thing to do.
Bond people ignored Mr. Greenspan's failure to intervene in the stock bubble because the resulting collapse was the most lucrative bond-market interval of a lifetime (never doubt the extent of self-interest among bond types: Philistines we are, all of us...).
However, from November of '02 through April '03, Mr. Greenspan created the appearance that the Fed would act to drive down long-term interest rates in a way it had not for half a century -- by buying bonds itself. In May he said so in unambiguous public testimony. Markets trusted him, buying bonds themselves.
In the last week of June he reversed himself. Whether he was late to understand the market-moving effect of his prior words, or because a rebounding economy reduced his fear of disinflation, or because he became unconvinced that the bond-buying strategy was feasible, the result was the greatest bond market loss-panic in modern history. The 10-year note yield rose from 3.10% to 4.65% in two months -- a fifty percent increase -- on the assumption that the Fed would begin to raise its overnight Fed funds rate from 1.00% at any time without warning.
Forgiveness is not available in markets; trust is available, but once broken is often impossible to restore. Since the late-June fiasco, Mr. Greenspan delivered a defensive speech at an August convention of central bankers (no eggs or overripe fruit, there), and has otherwise been invisible -- possibly hiding in the same cave beside Osama, Cheney, Hussein, and the Cub fan.
The Fed's Briefcase Drill Team has been out every week, trying to take back the market's fear of Fed tightening. The Team has had some success with its we-won't- tighten "...for the foreseeable future....", as measured by the 10-year note's stabilization near 4.25%.
However, no matter what the Fed would like the bond market to see, or when, in plain bond-market sight is the Fed's effort to ride three horses at once: get inflation back up to 2%, then tighten to keep reflation from turning into inflation, and pull off those tricks without doing harm to the recovery.
I had some cowboy uncles in Oklahoma who could ride two horses at once, but they were trustworthy men.
The Fed's trick ride would be risky even if everybody had faith; as it is, a stumble seems inevitable. I hope the horses come through okay, but the rider is on his own.
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