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February 18, 2005
Mortgages traded up this week from too-good-to-be-true 5.50% to 5.75%, taken there by a surge in the 10-year T-note from just under 4.00% ten days ago to 4.26% this morning.
The first leg of the rise was unmistakably Mr. Greenspan's work; the second, today, from new data suggesting of inflation.
In reverse order, data first: the core rate of January producer-price increase shot up .8%, but was overstated by oddities: tobacco, alcohol, and withdrawal of auto-price incentives. Claims for unemployment insurance have fallen to the 300,000-weekly zone, best in five years, and housing starts reached a 21-year high (insistent housing-bubblologists might note that US population reached a 229-year high).
Mr. Greenspan wore his age well in his testimony to Congress, his mind bright and clear, but vigor -- his sheer force of personality -- on the wane. Now eleven months to retirement, he gave us one more oblique caution, intentionally imprecise but his usage guaranteed to emphasize: "For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum."
Broadly unanticipated... no foolin': nearly everybody for two years has been certain that bond yields would rise. The Fed has raised its overnight cost of money from 1.00% to 2.50%, and bond yields have come down from 4.80%. Late in tightening cycles such a "yield curve flattening" is routine, and a warning of recession to come; early in tightening cycles... flattening just doesn't happen.
It has, now. Could the flattening be a warning to the Fed that it is in the process of over-doing its rate hikes? "This interpretation does not mesh seamlessly with the rise in stock prices and the narrowing of credit spreads....", and, "...only a portion of the decline... is attributable to a drop in long-term inflation expectations."
The Chairman knows that everyone in the markets knows that the Fed takes very seriously bond-market signals as to its policy. He also knew while composing his remarks that his "conundrum" line would be the centerpiece. Did he intend a warning? You bet! However, commentators since who say he intended to correct a bond-market misinterpretation, and to drive yields up where they belong... I am struggling to remain polite to those like PIMCO's McCulley who announced today that the Chairman meant to say that bonds are "...in a bubble, but he couldn't say that."
Mr. Greenspan says exactly what he means; a "conundrum" is a riddle, one quite likely puzzling to himself as well. If he intended to expose market foolishness, he was perfectly capable of doing so, as he has before with fearless exuberance.
It may be that foreign central bank mania for accumulating dollar reserves is causing a distortion, or demand for long assets to offset pension liabilities, or any number of things, including foolishness.
On the other hand, bond-market behavior may be flashing the traditional warning: stocks look shaky, not strong; credit spreads are narrow, but maybe because investors desperate for yield are over-paying for lousy credit. The most important news of the week has been ignored: in new revision, Japan is back in recession, its economy contracting in the last three quarters of '04, and Germany and Italy slipped to negative GDP in the 4th quarter. Bond yields are down or falling everywhere as economies falter under the weight of aging populations, and their dependence on America to soak up their exports, frustrated by a weak dollar.
Two more things from the Chairman, ignored: "...The real Federal funds rate... remains fairly low" --"fairly" is near-neutral language. Second, he described lagging capital investment as "most unusual", and a continuing drag on hiring.
I think it wise to take the Chairman at his word: this is an atypical economic recovery and global situation, a conundrum to reveal itself on its own.
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