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To: Les H who wrote (3595)	11/15/2002 2:16:28 PM
From: TREND1	Respond to of 29602

Les Two very interesting articles on interest rates. I am still trying to understand how China taking over the "world production of goods" and "deflation like the 1930's" are changing how interest rates act upon our economy. Larry Dudash

To: Les H who wrote (3595)	11/18/2002 3:20:24 PM
From: Alastair McIntosh	Respond to of 29602

Jeff Rubin on the yield curve flattening: Wait for the yield curve to smooth out and bonds will hit it big By JEFFREY RUBIN Monday, November 18, 2002 I'd like to think that my call a couple of months ago in this column for a 1-per-cent U.S. federal funds rate looks pretty good right now. After the 50-basis-point cut by the Federal Reserve Board at its last meeting, we're getting to that target even sooner than I thought. And the economic numbers out of the United States are getting weaker, not stronger, which suggests that, Fed reassurances aside, it has probably not done cutting. But readers will also recall that I bought bonds, and the rally in bond yields has been decidedly less impressive than what might be expected from the Fed cut. With 365 basis points now between the federal funds rate and the yield on 30-year U.S. Treasury bonds, somebody on the yield curve is very wrong. (A basis point is 1/100th of a percentage point.) Obviously, with most of my own portfolio in 30-year Government of Canada bonds, I'm betting heavily that it's not me. Happily clipping a 5.75-per-cent coupon, I can afford to be patient. At least, a lot more patient than someone getting less than half that in cash. Where else do you get that kind of interest rate with absolutely no default risk? In a world where Ford Motor Co. debt is trading like a junk bond, no-default guarantees don't come cheap. Yet to come are the capital returns that I advised bondholders to expect. Note that the total return from holding a bond is not only the coupon it pays you, but also the shift in its price as its market yield changes through trading. If market yields fall, the price of a bond rises, giving the holder a capital gain in addition to the coupon payment. Of course, the converse is also true. Left on its own, the bond market will right itself in my favour. Without a credible economic risk for monetary tightening, the very steepness of the yield curve will gradually act as an incentive for investors to extend term. As fund managers pursue more yield by sliding up the curve, the demand for, and prices of, long-dated government bonds will rise. As demand bids up price, their yields will fall, until the interest rate differential along the yield curve no longer motivates the movement of capital from short-term interest rate instruments to long-term instruments. Of course, the real issue is what a normally shaped yield curve looks like. Most will agree it's not the 365 basis points today that lie between the federal funds rate and the 30-year Treasury bond. Historically, it's been half that amount when the level of interest rates themselves were much higher. Few on either side of the yield curve would bet the distance between them can remain as large as it is today. But the prevailing view in the bond market is that short-term interest rates are too low, not that long-term interest rates are too high. While the market might partly expect another 25-basis-point cut by the Fed, deep in its belly it feels that short-term interest rates must ultimately rise, and rise substantially from where they are today. While such sentiment does not fade easily, it is increasingly challenged by where short-term interest rates have actually gone over the past several years. Was the bond market not similarly disbelieving of the permanence of a 2-per-cent funds rate little over a year ago? Back then, the Treasuries market was pricing in 100 basis points of Fed tightening over the next year. Instead, the Fed has subsequently eased 75 basis points, yet 30-year bond yields have hardly budged. The big gains to bondholders won't come with a further Fed rate cut. With the curve already so steep, what's the difference between a 1- and a 1.25-per-cent funds rate for a holder of a long-term government bond? It's not a lower funds rate per se, but rather the recognition that today's funds rate is here to stay, that will ultimately flatten the curve. It took the Japanese government bond market almost three years to figure out the same thing about the Bank of Japan. A similarly steep Japan government bond curve was ultimately forced to recalibrate its longer-term expectation of future interest rates, as a zero overnight rate is now seen as par for the course. How long it will take the North American market to get the same message remains to be seen. But when it does, holders of long-term government bonds will see double-digit returns, and clip 5-per-cent-plus coupons while they are waiting. Jeffrey Rubin is chief economist and managing director of CIBC World Markets. Copyright © 2002 Bell Globemedia Interactive Inc. All Rights Reserved.