Issue 26 - June 9, 2005


Measured Conundrum: What’s a Federal Reserve to do?

Since last summer the Federal Reserve has increased the benchmark rate to 3% in eight “measured” steps. During the same period, long-term U.S. Treasury rates have rallied by decreasing almost 75 basis points. This “conundrum” behavior is – at the very least – unprecedented. As market participants try to make sense of these diverging trends one thing remains true: short term rates remain accommodative.

Possible Explanations

The Slowdown Theory. A significant slowdown or recession is one of the explanations that bond bulls use to justify this year-long rally. However, with the unemployment rate now down to 5.1% and GDP running north of 3%, it would be hard to see a U.S. economy on the verge of a material slowdown. Furthermore, the idea that the market is telegraphing future events appears shaky. NASDAQ 5000
only told us in hindsight that the technology market was overbought.

The Supply & Demand Theory. The U.S. Treasury’s move to shorter-dated issuance has coincided with rising demand for long-duration assets. Investor needs are surely a key factor in keeping long rates down, but are they enough to drive rates to or through short-term levels? Maybe, but an inverted yield curve where short rates are cheaper than long rates is inherently unstable and a situation that is unlikely to persist.

The Globalization Defeats Inflation Theory. Globalization has certainly reduced pricing power in many industries. However, much has been written recently
about the fact that current measures of inflation fail to capture increasing costs associated with such necessities as housing, education, and healthcare.

Complacency towards inflation combined with supply and demand could account for much of the market’s enthusiasm for the long-end of the U.S. bond market. There is a fine line, however, between enthusiasm and greedy bubble behavior. Any substantial reversal in bond market sentiment could result in some nasty principal losses as small current coupons will provide very little price cushioning
in negative markets.

Implications of an Uncoupled Market

There is an old saying about only worrying about the problems that you can do something about. This might be applicable to the Federal Reserve today. Fed policy only concerns short-term rates. The Fed has no say in how the market prices the long-end of the yield curve. Real rates (net of inflation) are still in negative territory, despite 200 basis points of tightening in one year. Will the Fed take a pause when real rates reach zero? They certainly could, but they would also be well within their mandate to continue raising short rates. Whether real rates are negative or even zero, they are accommodative. The implications of this policy for the real estate market are crucial; leaving policy accommodative does nothing to reign in the pace of the real estate market.

Alan Greenspan’s cautious comments on the eve of his departure after 18 years
at the helm of the Fed bear listening to. For now he is, after all, the one setting the policy.


In this Edition

  • Measured Conundrum
  • Possible Explanations
  • Implications of an Uncoupled Market

Huntington Steele

925 4th Avenue
Suite 3700
Seattle, WA 98104



Past Issues

25 - 04.13.05
1st Quarter 2005:
Up, Down, Sideways
Calm on Top, Turbulence Below
What's on Deck?

24 - 03.09.05
Housing: Priority
#1 for the Federal Reserve
Calling the Top Again
Policy Implications

23 - 02.11.05
Interest Rates and the Federal Reserve
A New Demand Paradigm
No-Traditional Buyers
4% Looks Good
Chicken & Egg Market

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

More Past Issues
can be found in our

Newsletter Archive


Market Highlights

    05/31/05 03/31/05 12/31/04 12/31/03
DJIA US 10467.5 10503.80 10783 10453.9
S&P 500 US 1191.50 1180.59 1211.92 1111.92
Nasdaq US 2068.22 1999.23 2175.44 2003.39
EAFE Int'l Equity 1468.92 1503.85 1515.48 1288.77
5 Yr Treasury 3.764 4.21 3.649 3.231
5 Yr AAA Muni 3.050 3.29 2.79 2.45
10 Yr Treasury 4.032 4.512 4.257 4.225
10 Yr AAA Muni 3.57 3.920 3.64 3.6
30 Yr Treasury 4.299 4.731 4.817 5.01
30 Yr AAA Muni 4.39 4.580 4.58 4.54
EUR Currency 1.2324 1.2958 1.3652 1.2612
JPY Currency 108.18 106.88 102.48 106.92
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