A great story on the 1st Q interst rate cyle:"Traders Adjust to Greenspan's Talk of Higher Rates,But Are We Witnessing Just a Seasonal Oddity?
By William Pesek Jr.
Turning bearish on bonds last month wasn't an easy decision for Dennis
Hynes. Like most veteran Wall Streeters, Hynes had been expecting interest
rates to fall further this year. Surely, he thought, weak economic growth
abroad and an inevitable slowdown in the U.S. would force Alan Greenspan
to cut interest rates, pushing up bond prices.
But on February 5, Hynes faced a different reality, namely, a steady flow of
news on employment and consumption showing that the U.S. economy was
raging ahead. Meanwhile, Asia and Latin America seemed to be stabilizing.
So Hynes, who is managing director at the investment firm R.W. Pressprich,
changed his outlook on interest rates and broke the bad news to his bond
salesmen. As Hynes remembers, "Their reaction was 'Are you nuts?' "
As it turned out, Hynes wasn't crazy
at all. Last week, Greenspan hinted in
his semiannual Humphrey-Hawkins
testimony before Congress that the
Federal Reserve may need to raise
interest rates. While he also pointed to
a number of risks to continued
economic growth, Greenspan
questioned whether the current
inflation-free run was ending. Wall
Street didn't miss a beat, driving up
short-term and long-term rates in a
massive effort to adjust to this new
view.
For the first time in six months, all Treasury securities with maturities of two
years or more are yielding more than 5%. This is hardly what a panel of 23
analysts polled by Barron's just two months ago envisioned. On average, they
thought the Fed would ease interest rates by a half- percentage point this year
and that the yield on the 30-year Treasury bond would stand in the 4.85%
range. But the 30-year yield rate ended last week at 5.58%, up from 5.39% a
week earlier. And the upward grind in yields may not be over.
Greenspan's fear that strong growth and tight labor markets have left the
economy "stretched" seemed prophetic as surprisingly robust data rolled in
last week. New orders for durable goods jumped 3.9% in January,
confounding expectations for a decline. Instead of the projected 2.2% slide,
existing-home sales rose 0.8% in January.
The economy's impressive performance prompted Greenspan to question
whether the Fed may need to take back some of the three-quarters of a
percentage point that was cut from short-term rates last year. The central
bank, he said, must evaluate "whether the full extent of the policy easings
undertaken last fall to address the seizing-up of financial markets remains
appropriate as those disturbances abate."
But a Fed tightening is hardly a fait accompli, and some would argue it
remains a longshot. Greenspan also discussed a variety of risks facing the
U.S. this year, including a stock market selloff and weakening economies
abroad. Against that backdrop, he confirmed that the Fed is in a
"wait-and-worry" mode.
Yet Fed watchers were struck by some of the more subtle points of
Greenspan's testimony. Marilyn Schaja of Donaldson Lufkin & Jenrette points
out that a summary of the Federal Open Market Committee's December 22
meeting suggested a disposition toward further rate cuts. Little was said of
higher borrowing costs. But last week, Greenspan stressed that monetary
policy "must be ready to move quickly in either direction." As Schaja sees it,
"There's been a slight, but bearish, shift in emphasis."
Kathy Jones of Prudential Securities
thinks investors read too much into
Greenspan's words. Bond futures
traders, for example, are now
anticipating a
quarter-percentage-point hike in the
federal funds rate target, which now
stands at 4.75%.
Faced with a wobbly stock market,
weak international economy and
commodity price trends signaling little
in the way of inflation, the Fed's in no
hurry to nudge rates higher. More
likely, Jones argues, policy makers will continue to conduct "open-mouth
operations," talking about higher rates so that the bond market will tighten
enough to save policy makers the trouble.
Of course, if recent history is any guide, last week's rise in rates may be a
buying opportunity, a dynamic seen last Friday. Stuart Hoffman of PNC Bank
points out that the ongoing rise in yields may be part of a familiar pattern. In
each of the last three years, Treasury bond yields began to surge in
mid-February, only to decline by April.
In 1996, yields bottomed at 6.02% on February 13 and rose to a peak of
7.12% by the end of April. The following year saw rates at 6.53% on
February 14 before topping out at 7.14% in April, and dropping again. And
in 1998, yields climbed from 5.80% in mid-February, peaked at 6.08% in
April, and fell again. Today's bond market rout began February 12, and the
trend may well reverse itself in coming months.
Hoffman attributes the seasonal pattern to the U.S. economy's tendency to
carry considerable momentum into each new year. Sure enough, the opening
quarters of the year have been impressive since 1996. The first quarter also
tends to fall prey to the approaching end of Japan's fiscal year on March 31.
Tokyo-based investors often sell U.S. bonds to return funds to Japanese
markets, thus driving up America's interest rates.
This year it looks like the economy's strength is causing a repetition of the
first-quarter effect on bond yields. Gross domestic product rose a
mind-numbing 6.1% in the fourth quarter (revised upward from 5.6%), and
recent data indicate that healthy consumer confidence is dashing hopes for a
significant slowdown this year. Once again, figures for January signaled the
start of Japanese capital repatriation, prodded along by a large jump in yields
on Japanese government bonds.
U.S. bond rates, meanwhile, have risen 49 basis points from the 5.09% rate
seen in early February. But Hoffman does not expect a repeat of 1996, which
saw the yield on the 30-year bond surge by 1.1 percentage point. We are
more likely to see an increase from the trough of a half-point or perhaps
three-quarters, which was the magnitude of the 1997 rate rise. If so, we could
see a rate peak of 5.75% on the 30-year Treasury by April. But those rates
may not last.
"We see Treasury yields above 5.50% as a buying opportunity," Hoffman
says. Others seemed to agree last Friday as bargain hunters stepped up to
take advantage of rising yields. The scattered buying came after the bond
yield hit 5.65%, the highest level since last August.
Even if the bloodbath proves
temporary, the week ahead poses
some major challenges for the bond
market. More evidence that the
manufacturing sector has stabilized
could be confirmed by the National
Association of Purchasing
Management's February survey. Also,
a meeting of the National Association
for Business Economists will feature a
speech by Fed Governor Roger
Ferguson. And the February
employment report may cause some
problems. Analysts expect a solid
increase of 250,000 in nonfarm
payrolls.
Asia rising? The region's economy is "clearly on the mend," predicts
International Monetary Fund Managing Director Michael Camdessus. IMF
analysts, he says, are now confident South Korea's economy will have a 2%
growth rate this year, instead of the deep recession envisioned just a couple of
months ago.
Yet Japan continues to slide. "Japan is still weakening," Greenspan said last
week. "I don't think it's flat yet."
Nonetheless, yields on Japan's 10-year government bonds ended last week
yielding 1.89%, an increase from 1.76% a week earlier. While the rate is
down from the 2.4% range seen in early February, Wall Street will be
watching closely to see if the Bank of Japan will continue its recent efforts to
halt the rise in Japan's long-term rates. |
