U.S. Interest Rates: Split Personality

Article excerpt

The Fed has been pushing short-term rates down aggressively. but longer-term rates have been rising. Now traders have to make the shift to dealing with a 'normal' yield curve.

Anyone who has any interest in interest rates is well aware of the attitude of the U.S. Federal Reserve in this market this year. After ending a tightening phase with a final 50-basis-point increase to bring the Fed funds rate to 6.50% on May 16, 2000 -- one squeeze too many, some believe -- the Fed sat on its hands during the rest of 2000 as many sectors of the U.S. economy went into a sudden, sharp slowdown. That position reversed completely when 2001 arrived.

Only a couple of weeks after declining to reduce the Fed funds rate, the Fed surprised virtually everyone Jan. 3 by cutting rates by 50 basis points. That was the first of five 50-point cuts that took the Fed funds rate down to 4.00% going into the Fed Open Market Committee (FOMC) meeting at the end of June (see "Mark your calendar," page 28). Two of the cuts were inter-meeting cuts as the Fed revealed its anxiety to head off recession during its most aggressive posture during the reign of Fed Chairman Alan Greenspan.

Unlike 2000, the question was not whether a FOMC meeting would produce a rate reduction but whether the cut would be 25, 50 or even 75 basis points. Even the 50-point cuts turned out to be a "disappointment" or a widely anticipated event that evoked yawns from many traders.

However, while the Fed was pushing short-term rates lower, the effect on longer-term rates was somewhat different: After bottoming in March, long-term yields began to rise (see "U.S. Treasury yields," page 28), and bond and note futures fell into a downtrend. With a powerful force like the Fed on the other side pushing rates lower, rising long-term rates might seem like a most unlikely response. But there's a rather simple explanation.

"The bond market has become a very forward-looking market," says Mark McClellan, managing editor of the Bank Credit Analyst's U.S. fixed-income monthly publication based in Montreal, noting that bond rallies at the end of 1998 and 2000 anticipated weakness in the economy and a soft stock market. "The bond rally had gone a long way even before the Fed started to ease."

Bond futures reached a new high in March when the Fed reinforced its intention to act vigorously to head off an economic downturn in the wake of weak data, higher energy prices, a falling stock market and declining consumer confidence. Then interest rate traders began to look ahead, across the chasm that would mark an economic bottom to better conditions in the second half of the year. In a "good-news-is-bad-news" and "bad-news-is-good-news" type of reaction, traders reasoned that the worse the economic reports were in the first half of the year, the more likely the Fed would do whatever it had to do to prevent a recession.

When the Fed cut rates another 50 points on May 15, many traders expected that would be the end of the line for Fed easing. However, data such as employment figures and the National Association of Purchasing Managers (NAPM) index continued to show a weak economy, and the debate going into the June 26-27 FOMC meeting was a familiar one: Would the Fed reduce rates again to stimulate the economy? If so, would the reduction be 25 basis points or 50 basis points? And would that be the end of the Fed's current easing cycle?

In general, economists think that. whatever happens to the economy, the Fed bias on rates will change in the second half of the year. When and where they expect that to occur depends on how they are reading and interpreting economic data. As expected, they don't agree on that any more than they agree on whether there will be a "V' or a "U" or some other type of bottom.

Vince Malanga of LaSalle Economics Inc. believes that "non-energy capital spending will remain weak through 2002 with the ever-present risk that this weakness spills into consumption and residential construction. …