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June 18, 2004
For the second week in a row, Alan Greenspan talked a jumper off his ledge.
On Monday, the whole interest-rate structure rose to new highs out of fear that the Fed is about to begin a severe campaign -- perhaps opening with a half-percent increase on June 30. If only .25%, the Fed is still headed way, way above the 1.00% rate of the last year-and-a-quarter. Even if the rate-rising campaign is gradual, a twenty-year decline in interest rates has concluded.
Rates on everything soared on Monday: the 10-year T-note to 4.85%, the Fed-sensitive 2-and 5-year notes to 2.90% and 4.08%, respectively, and 30-year, fixed-rate mortgages to 6.50%.
The Chairman is not a bullhorn-in-the-street type, gathering the jumper's sobbing family to plead with him; no, he's the soft-talker in the window beside the poor guy. "Calm down... Inflation is okay... If it's not, we'll do something about it... Really, come on in...." This soothing performance in the Senate on Tuesday knocked the whole yield curve back down to where it was last week, mortgages to 6.25%.
Mr. Greenspan's rescues of the bond market in these last two weeks were not born of Samaritan altruism, but self-interest: his extended family is down in the street, and if the jumper takes a dive, he could wipe out the whole lot. The bond market ought to be worried -- the Fed is coming -- but the Chairman must do everything in his power to prevent a premature suicide by the bond market. If a Fed-panic overtakes bonds, and long-term rates scurry up another percent, that could abort the new-found modest inflation, the recovery, and the economy.
The Fed wants to re-structure interest rates, not to raise all of them at once. For his last act on stage, Mr. Greenspan would like to raise short-term rates by perhaps 2.00% in the next year, but have long-term rates increase by only .50%-1.00%. (Yes, his last act: the Chairman will retire on or before January 31, 2006, a very short 19 months from now.) The bond market knows that the Chairman intends this nice, polite, orderly readjustment, but fears that the man in the window with the reassuring voice may stop talking and instead toss a banana peel onto the ledge.
If inflation stays under control, near 2.00% in core CPI, then the Chairman's exit will be peaceful. However, if inflation doesn't stay under control, then the Fed cannot stop with a re-set to neutral, but must tighten right on past 3.00%. It will have to lean into the economy, switching from hoping the bond market will not abort the economy to hoping that a sharp rise in long-term rates will slow it down.
The market for long-term money spends all day, every day trying to anticipate the long-term future. If it knows the Fed is coming, even if gradually, then it wants to get the damage over with. Not by inches, not in a series of crippling leaplets from the second-story window, but get it over with: sell everything, now, until it's safe to own bonds again -- at the soonest, when the Fed has concluded its return trip to neutral.
Meanwhile -- the Chairman's reassuring charm notwithstanding -- all the data say that the economy is so hot that the odds favor inflation going out of control. The key datum this week: the fraction of industrial capacity in use jumped to 77.8%. After two years mired at or under a recession-level 75%, we are close to the pink-of-health 80% at which businesses tend to raise prices. Another too-much-good-news indicator for bonds: tax revenue is rising at last, both at the federal and state level, indicating that job growth is real, and paying real money.
Mortgage rates will remain on the ledge until some sign of a moderating economy offsets the inevitability of the Fed's march to neutral... or beyond.
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