Tuesday, July 25, 2006

The Fed, long-term interest rates, and other unrelated data

In February 2005, Alan Greenspan famously described the decline of long-term interest rates in the face of rising fed funds as a "conundrum." While the 30-year Treasury yield is now nearly 100bp higher than its lows, its yield is basically unchanged since April 2004, when fed funds was 1%. To look at the chart on the two rates, you would certainly suspect these two time series are completely unrelated.

(I have a chart, but Blogger's image upload tool is down.)

We can debate the reasons why the two rates have disconnected. Pension problems are currently in the news, as Congress is nearing pension reform legislation. We all know that pension funds are major buyers on the long-end. I am a big believer in the Fed credibility theory, which is that while near-term inflation may ebb and flow, the Fed has a good handle on long-term inflation, and therefore there is no reason for long rates to respond to short-term inflation fluctuations. Since investors view long-run inflation as a low risk, they require less of a risk premium to own long bonds.

Regardless of the reason why long-term rates have been sticky through this Fed cycle, the real question is will they be sticky through the next cycle? Right now, we are hearing some bond managers sound more bullish on rates, including the famous Bill Gross. But how to express a bullish stance? If long-rates are sticky, you may buy long bonds and see little or no price appreciation. Meanwhile it may be 5-7 year bonds that see all the price appreciation.

"Things are different now" are probably the four most dangerous words in investing. Its the mantra that hoodwinked people into buying tech stocks in 1999. But the truth is things are always different now. There are just too many variables impacting the economy for any one situation to be the same as another situation. For example, Justin Lahart of the Wall Street Journal recently compared now to 1994-1995. Then we had a well-established FOMC chair, falling oil prices, and a more stable geo-political situation.

We in the investment business owe it to our clients to rationally analyze whether a fundamental change has occurred in the relationship between short and long-term interest rates. I think there are a lot of bond buyers who are figuring the 2004-2005 experience was a one-time event, and the relationship between short and long-term rates will return to a more normal pattern. Whether that's right or wrong, I think that's inadequate analysis.

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