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March 11, 2005
All long-term rates have broken sharply higher since Wednesday. The 10-year T-note at 4.53% is well above the prior eight-month high at 4.41%, and the lowest-fee, 30-year fixed-rate mortgages are in the process of crossing 6.00%.
As always during abrupt changes in market psychology, the financial chattering class has been seized by alarm, saying that these rate increases are the first stage of an inevitable collapse in the dollar, or inflation is out of control, or the economy is overheating, or some other end-of-life-on-earth shriek.
I think it much more likely that one, single force more powerful than all the other ones combined is at work: just the Fed.
Beginning with the evident victory over deflation in the summer of 2003, the bond market began to anticipate a sustained tightening by the Fed, first to remove excessive stimulus, then to lean against resurgent inflation, if any, as necessary. The bond market's anticipation was overdone in 2003 and in 2004. In both years, 10-year Treasury yields approached 5.00%, taking mortgages above 6.50%, only to fall back nearly a percent each time as the economy faltered and delayed the Fed's need to remove accommodation.
Now sustained tightening is at hand. In just the last ten days, economic data has shifted from iffy to robust. All the theories for fragility and pending slowdown -- fading effects of tax cuts, consumers on the edge, effects of higher rates -- have failed to pan out. Yeah, bonds were in premature worry in each of the prior two springs, but the economy was not then so strong, there was no inflation threat from $55 oil, the federal deficit was not so totally and irresponsibly out of control, and that deficit not so excessively stimulating the economy.
Now the Fed is six rate hikes into a cycle, and March 22 will make it seven, to 2.75% fed funds. A lot of people -- led by the Bond Gods at Pimco -- thought the Fed would reach a neutral fed funds rate at 2.50%, where we are now, or stop at 3.00%, or certainly stop at 3.50%. Forget all that. Maybe they will stop in the threes, but only if something big breaks: the stock market, or housing, or the Congressional and Administration fools of both parties who think a $500 billion budget deficit is okay.
Evidence: no Fed speaker has so much as speculated on the location of a "neutral" fed funds rate, nor indicators precedent (total silence on the appropriate fed funds spread above inflation -- the "real" rate). However, the Fed's December minutes painfully noted, "The extent to which the federal budget deficit would decline over coming years was an open question." Since, the Chairman has fairly shouted warnings of higher rates and "stagnation" unless the budget comes under control. The Fed does not yet need to lean into inflation, but it must lean against the deficit.
Mr. Greenspan's "conundrum" -- low long-term rates in the face of rising short-term ones -- is now solved: the bond market had not understood how far short-term rates were going to rise. Long-term rates are at last rising because the Fed has pushed short rates up enough to bulldoze the longer ones. If the Fed is now a lead-pipe cinch to be 3.50% by Labor Day, the 2-year T-note had to rise to at least that level; if the 2-year went to 3.70% (as it has this week), then the 5-year T-note had to rise from the 3.90%-range to 4.20% to have some spread return for longer risk; if the 5-year went to 4.20% (as it has), then the 10-year T-note had no business under 4.50%, and is no longer.
Facing a Fed headed for 4.00% or more, the 10-year ought to be 4.75%-5.00%, and mortgages pushing 6.50% as prime crosses 6.00%, headed for 7.00%-plus.
That's what's going to happen unless something breaks: stocks, housing, or politicians. Not a terribly pleasant prospect, but also NOT the array of dollar and inflation catastrophes back-to-back-to-back on CNBC.
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