Saturday, February 19, 2005

Bond market confounds even Greenspan

By Rachel Beck / AP Business Writer

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NEW YORK -- The way the bond market has been behaving lately shows why looks can sometimes be deceiving. While prices keep rising and yields are coming down, not everyone is convinced that's good news.

That's because expectations had been for the bond market's rally to subside in recent months, a result of the strengthening economy and the Federal Reserve's steps to keep growth in check.

Yet all that has happened since the Fed shifted to a tightening policy last June is that short-term rates have headed up, while the yield on the 10-year Treasury note has tumbled.

Home buyers looking for attractive mortgage rates and corporate borrowers are the immediate beneficiaries, but it hasn't stopped worries from mounting over what's really driving this unexpected turn of events and what it means for the economy.

Fed Chairman Alan Greenspan didn't help much this week to temper those concerns. While testifying before a congressional panel on Wednesday, he said Fed officials have been "confounded" by the bond market's reaction to its monetary policy.

"For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum," Greenspan told the Senate Banking Committee. "Bond price movements may be a short-term aberration, but it will be some time before we are able to better judge the forces underlying recent experience."

This confusion wasn't expected when the Fed began its policy shift last summer by boosting its target for the federal funds rate, the rates banks charge each other on overnight loans. That rate now stands at 2.5 percent after being bumped up six times by a quarter percentage point since June.

Since then, however, bonds have rallied and the yield on the 10-year Treasury note plunged to below 4 percent earlier this month -- far from the 4.6 percent it was when the Fed switched to its rate stance. The yield has since risen to about 4.2 percent after Greenspan suggested in his congressional testimony that the economy is in good shape and central bankers will continue raising the overnight rate.

The decline in long-term yields while short-term rates are rising is causing the yield curve -- charted by plotting the yields of the various maturities of securities the Treasury sells, from 3-month bills to 10-year notes -- to flatten in a way not seen in the recent past. Normally, a flattening curve happens when the Fed raises short term rates more quickly than long-term rates are rising.

Since the start of the year, the difference between two- and 10-year yields has been narrowing, from 1.16 to around 0.75 percentage points this week, according to U.S. Treasury data. The spread when the Fed began raising short-term rates on June 30 was 1.92.

Given that compression, the market is buzzing over whether the curve could eventually invert. Only three times in the last 30 years have two-year yields exceeded 10-year yields, according to Lehman Brothers U.S. economist Ethan Harris.

No wonder this market is under close watch.

Often when the curve flattens, the bond market can be signaling that its seeing troubling economic times in the not-so-distant future. Charles Schwab chief investment strategist Liz Anne Sonders points out that is what happened in the spring of 2001 when there was severe economic and market weakness.

That theory, though, has been challenged by Sonders and many others this go around. They point out that other financial markets haven't been rattled by such concerns, and note that the Fed even has raised its forecast for gross domestic product in 2004 to a range of 3.75 percent to 4 percent up from 3.5 percent to 4 percent.

These low yields also are working against the Fed's efforts to remove liquidity from financial markets. Just look at the housing market, which continues to soar thanks to low mortgage rates. There is some concern that market could be getting overheated.

The flattening yield curve could turn out to be troubling for banks and institutional investors who make their money borrowing based on short-term rates but lending at higher longer-term rates.

Many economists caution to not read into this flattening curve too much. They say that there may be technical factors at work that are keeping bond prices up and yields down.

For one, the Fed's decision to raise rates at a "measured" pace could be fueling some short-term buying by those who think they can profit before the market finally changes its course. Potential corporate pension reform could also be driving companies to begin buying bonds over stocks.

And the Treasury's decision to stop selling 30-year bonds three years ago may be creating a supply squeeze as demand for five- and 10-year notes rises from companies and investors who need those securities as part of hedging strategies.

Still, unless bonds suddenly switch their ways, they will stay under close scrutiny as the Fed continues to raise rates in the months ahead. All we can hope is that bond investors don't know something the rest of us don't.

Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck@ap.org