The bond market’s rally in recent months looks to be the work of a new generation of “vigilantes” who have turned the notion of holding the Federal Reserve’s feet to the fire on its head.
Back in the 1980s and early 1990s, these investors took matters into their own hands when they felt the Fed wasn’t doing enough to fight inflation. By selling bonds, they pushed rates on things like 30-year Treasury bonds high enough to slow the economy in the hopes of warding off the stinging effect of higher prices. The Fed eventually followed suit by increasing overnight rates.
This go-around, a new class of bond investors seem to be working the opposite way. They are knocking down rates of Treasury securities in what amounts to an audacious gamble that Fed Chairman Ben Bernanke and his colleagues soon will have to reverse course and cut short-term borrowing rates to avoid a recession.
As some on Wall Street have pointed out, this change in tactics may have something to do with who manages money these days: Hedge funds and other speculators play an ever-larger role in the bond market and the pressures they face to show outsized returns are intense.
That’s one way to explain the Treasury rally that no one saw coming and which is equally as important a story as the Dow Jones industrial average’s recent record-setting run.
Just months ago, bond prices were falling while yields, which move in the opposite direction, were heading up. As inflationary pressures rose — namely oil and commodity prices soared — investors wanted out. They hate inflation because it decimates the purchasing power of the funds they get repaid when bonds mature.
But their views started to change in the middle of July, after Bernanke testified before Congress that he expected economic growth and inflation would cool.
Soon after, oil prices began a steep retreat, dropping from highs topping $78 a barrel in July to less than $60 in recent days — a move that has calmed inflation worries. At the same time, there has been plenty of bad news on the economic front, especially in the housing and manufacturing sectors. That has raised concerns about the prospects of a recession, and sent more investors into the safe haven of bonds.
The Fed decided in August to keep the target for its benchmark short-term interest rate steady at 5.25 percent, breaking a streak of 17 consecutive quarter-point increases that began in 2004. Again at its Sept. 20 policy-making meeting, the Fed held its federal funds rate at that level.
Since the Fed pause, more than half the economic reports that have come out have been downside surprises, which is forcing analysts to cut their third- and fourth-quarter earnings estimates, according to Merrill Lynch.
Most notably, all this has sent yields on 10-year Treasury bills plunging to around 4.7 percent from 5.25 percent in late June. But yields on every other Treasury security, from three-month bills to 30-year bonds, also are trading below the funds rate. That’s what is known as an “inverted yield curve,” which historically has forecast tougher times ahead.
Sentiment in the bond market now is at a 3-year high, according to Morgan Stanley. Clearly, investors are predicting a weak outlook for the economy in the year ahead and are trying to do something about it before trouble really sets in.
Today’s investors seem to be betting that the Fed will start cutting rates in next year’s first quarter in order to breathe some life back into the economy. The Fed Funds futures contract has entirely priced out a Fed tightening for the rest of this year and trades as if there is a 19 percent chance of a rate cut at the Jan. 31 Fed meeting and an 50 percent chance of easing by March.
The question is whether the new bond market vigilantes are getting ahead of themselves. Fed officials, in recent speeches, have noted that the economy is indeed slowing, but inflation is still a serious concern.
Fed Vice Chairman Donald Kohn said in a speech last week that the decline in energy prices and contained readings on inflation expectations are “steps — albeit small — in the right direction.” But he said inflation remains “uncomfortably elevated.”
He also said that he was “surprised” at how little market participants share his sense that the “uncertainties” about growth, interest rates and inflation are fairly sizable.
Still, the bond market has been right before. Back in the fall of 2000, investors bet against the Fed’s tightening bias and were more concerned about the prospects of slowing growth.
The Fed seemed very focused on the issue of inflation, mentioning it 137 times at its October 2000 policy meeting, while the word “recession” wasn’t mentioned. By its December meeting, “recession” was said 24 times, and “inflation” was down to 83, according to Merrill Lynch. The Fed began cutting rates in January of 2001.
Bond investors won that bet. But its too soon whether the “vigilantes” will prevail this time around.