Issue 23 - February 11, 2005


Interest Rates and The Federal Reserve: Getting it Right

The Federal Reserve once again raised the benchmark Federal Funds rate by 25 basis points to 2.50% on February 2nd. Their mantra of “continuing to remove accommodation at a measured pace” suggests investors should expect further increases. While the short-term rate increases were widely anticipated by the market, the behavior of longer dated bonds was not. Surprisingly, long bonds rallied as their yields fell. The yield on the benchmark 10 year U.S. Treasury now stands at just over 4.0% after beginning 2005 at 4.25%.

While it is not unusual for long rates to lag behind rate increases by the Federal Reserve – a phenomenon known as yield curve flattening – it is highly irregular for long rates to fall in response to short rate increases. There are a number of possible explanations for this behavior and they each have implications for both stock and bond investors.

A New Demand Paradigm?

One simple explanation given for persistently low long-term rates is lessening supply and growing demand. Pension and insurance buyers have ever increasing needs for long-term investments while both public and private borrowers have opted to borrow in shorter maturities to take advantage of historical lows in rates.

While this scenario can explain part of recent market behavior, it cannot explain all of it, nor is not likely to persist. As the Federal Reserve continues to raise short-term rates the difference (or spread) in yields between short and long rates will be further compressed. Investors are unlikely tie up money in longer term bonds when they can earn essentially the same yield with significantly shorter-term options.

Non-Traditional Buyers

A number of non-traditional buyers with long-term investment horizons such as central banks and hedge funds have entered the market in the last few years. Unlike pension and insurance investors, these investors are far more discretionary in their buying patterns. If they choose to participate at all, they choose the timing and the duration of their investments. The declining dollar coupled with historical inflows into hedge funds has created demand for U.S. Treasury instruments which may or may not persist in the future.

4% Looks Good

Much has been written in the past year about the potential for a subdued outlook for U.S. equities. In this scenario, stocks are expected to return in line with Gross Domestic Product plus dividends. Faced with the possibility of reduced equity returns, investors might rightfully turn to bonds as an attractive risk-adjusted alternative.

However, if long-term bond yields were to stay this low for a protracted period of time, equity participants would have reason to believe that stock valuations would
be sustainable and that equities would return above historical standards not below. A yield of 4% looks less attractive in this environment.

A Chicken and Egg Market

While it is never easy to predict trends in interest rates, the last few years have featured an extraordinary number of unique cross currents. Each of the cases presented above has contributed to low long-term rates, but none of them has fundamentally changed the way that bond buyers invest. A further flattening of the curve and coinciding diminished investing opportunities will drive opportunistic bond buyers to higher yielding short-term maturities. As demand ebbs from discretionary buyers, longer-term rates should begin to normalize to a level consistent with a growing economy.


In this Edition

  • Interest Rates and The Federal Reserve
  • A New Demand Paradigm
  • No-Traditional Buyers
  • 4% Looks Good
  • A Chicken and Egg Market

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

22 - 12.02.04
Drooping Dollar
Not Everyone is an Investor
Implications for 2005
Putting the Euro in Perspective

21 - 11.04.04
Personal Savings
Absence of Rising Tide
US Elections

20 - 10.01.04
Coming or Going?
Speed Limit
Bond Market Showdown
Absence of Context

19 - 09.03.04
Aug '04/ Oil & Jobs/
Cooling of Hot Economy

18 - 08.03.04
July: A Difficult Stage

17 - 07.01.04
2004 Second Half Outlook

16 - 06.01.04
Big Bad Fed

15 -05.04.04
Rising Rates/ Google IPO

14 -04.01.04
First Quarter 2004

13 - 03.02.04
2004: Encore Performance

12 - 02.03.04
Market Outlook/Cell phones

11 - 12.16.03
Auctions - eBay, US Treasury, IPOs

10- 12.02.03
Recent Economic Data
Market Implications

More Past Issues
can be found in our

Newsletter Archive


Market Highlights

  01/31/05 12/31/04 09/30/04 6/30/04 3/31/04 12/31/03
DJIA US 10489.9 10783 10080.3 10435.5 10357.7 10453.9
S&P 500 US 1181.27 1211.92


1140.84 1126.21 1111.92
Nasdaq US 2062.41 2175.44 1896.84 2047.79 1994.22 2003.39
EAFE Int'l Equity 1486.97 1515.48 1318.03 1327.97 1337.07 1288.77
5 Yr Treasury 3.723 3.649 3.408 3.818 2.89 3.231
5 Yr AAA Muni 2.85 2.79 2.61 3.15 2.38 2.45
10 Yr Treasury 4.158 4.257 4.163 4.636 3.874 4.225
10 Yr AAA Muni 3.55 3.64 3.48 4.02 3.49 3.6
30 Yr Treasury 4.561 4.817 4.898 5.166 4.69 5.01
30 Yr AAA Muni 4.40 4.58 4.58 4.93 4.51 4.54
EUR Currency 1.3003 1.3652 1.2336 1.2157 1.2227 1.2612
JPY Currency 103.63 102.48 110.82 108.88


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