Monday, 13 February 2006

Federal Reserve tightening: Make-or-break year?

Last year, eight rate hikes by the Federal Reserve had little impact on long-term bond yields. Contrary to the fears of some economists who warned that the persistently low bond yields were an indication of a weak US economy, recent economic indicators have been relatively robust. However, similar intransigence in long-term bond yields this year is likely to have a less benign implication.

Alan Greenspan's last act as chairman of the Federal Reserve was to hike interest rates on 31 January, when the target federal funds rate was raised to 4.5 percent. It was the fourteenth consecutive Federal Open Market Committee meeting that had concluded with a rate hike, raising the target federal funds rate from 1 percent back in the middle of 2004.

One of the enduring puzzles -- Mr Greenspan calls it a "conundrum" -- of the past year has been the lack of response in longer-term US Treasury yields to this series of rate hikes. The 10-year US Treasury yield is currently around the same levels as it was back when the rate-hike campaign started. Indeed, as of Friday, the yield curve is actually inverted, with the 2-year yielding about ten basis points more than the 10-year.

Although the last FOMC statement was generally regarded to be less hawkish than previous ones, there is widespread belief that the Federal Reserve is still not done with rate hikes. If the Federal Reserve continues to hike rates while the 10-year yield stays around current levels, the yield curve could invert significantly. That, if history is any guide, signals a recession.

However, in my opinion, the 10-year yield is not likely to stay unmoved by further rate hikes. One of the reasons that it has responded little to the rate hikes so far is that at the time the Federal Reserve started its campaign, the spread between the 10-year yield and the federal funds rate was well over 300 basis points and did not drop below 100 basis points -- approximately its average for the past 50 years -- until around the middle of 2005. Such large spreads encouraged traders and investors to sell shorter-term maturities in favour of longer-term ones, thus keeping the yields for the latter down.

Since the spread dropped to around 100 basis points in mid-2005 -- with the federal funds rate at 3 percent and the 10-year yield at around 4 percent -- both rates have been on an uptrend, although with the latter more moderately so than the former.

The extent that the spread moderates changes in the 10-year yield in response to changes in the federal funds rate can be seen in the following chart.

The chart shows how, over each of the 50 years from 1955 to 2004, the change in the 10-year Treasury yield (shown on the vertical axis) has varied with the difference between the change in the federal funds rate and the spread at the beginning of each year (shown on the horizontal axis). It basically shows that a large spread mitigates the effects of hikes in the federal funds rate on the 10-year yield.

Over the course of 2005, the target federal funds rate was raised by 200 basis points. However, this amount was approximately where the spread stood at the beginning of the year. Fixed income investors looking for yield were never likely to be very impressed.

So the result of all those rate hikes in 2005 was just a small rise in the 10-year yield -- represented by the red square on the chart -- bang in line with what the average historical behaviour predicts.

Clearly, the gradual pace of rate hikes by the Federal Reserve in the presence of a wide spread has much to do with the lack of reaction in the 10-year yield.

However, with the spread now almost gone, further hikes in the federal funds rate are likely to elicit a greater response in the 10-year yield. If it does not, then we all know what that probably means.

This looks like the year that the Federal Reserve's tightening campaign finally breaks either the 10-year Treasury or the economy.

1 comment:

Anonymous said...

I think we are headed to double digit interest rates...

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