AVRUM D. LANK

All the Fed should do this week is wait

By AVRUM D. LANK of the Journal Sentinel staff

Sunday, August 10, 2003

When members of the Federal Reserve Board gather Tuesday to consider what to do about interest rates, a grill will be more useful than a laptop.

The meeting is being held only because it was scheduled, not because it is needed. Better to have a few burgers and beers than to worry about bond yields.

Why?

At the moment, “the markets are being more relevant than the Fed,” said Michael A. Roth, managing partner of Stark Investments, a hedge fund based in St. Francis.

Specifically, since the last Fed meeting in June, the bond market has run riot, with the yields on long-term securities rising as their prices plunged. As a result, the Fed does not need to do anything about rates right now.

If the Fed is correct in its optimistic belief that the economy is poised for a rebound later this year, then higher interest rates are appropriate as an insurance policy against inflation. This the bond market has provided.

But if the Fed is wrong, and the economy does not turn around more quickly, then leaving rates unchanged right now will not hurt anything, and indeed, give Fed Chairman Alan Greenspan and Co. more flexibility to deal with problems later on.

So no surprises are expected from the Fed on Tuesday.

It was surprises from the Fed in June and July that were the primary causes of the bond market’s recent flux.

In June, Greenspan was throwing around what Roth called “d- bombs,” that is, talking about the possibility of deflation. As a way to fight it, Greenspan suggested the Fed might buy long-term Treasury bonds. That would put dollars into the economy and also lower the prices of those bonds by increasing demand for them. When a bond’s price falls, its yield rises, which means interest rates go up.

Anticipating such a move, some investors began to sell long-term government bonds hoping to buy them back cheaper when the Fed entered the market.

But the Fed never did. In fact, last month, Greenspan indicated he was no longer worried about deflation, but instead saw the economy improving and maybe even inflating.

That, too, was a spur to the bond market. When there is concern about inflation, the yield on long-term bonds rises because investors want a great return for lending money for a longer time. So bond prices fall.

At that point, another factor entered the market — home mortgages. Mortgages interest rates are priced according to yields on longer-term Treasury securities. As those yields rose, so did mortgage rates.

That caused a slowdown in refinancings, meaning that existing mortgages would last longer. When that happened, the value of mortgage-backed securities, such as those held by banks and securities houses, fell, because their owners would have to wait longer to get their money back.

That caused real problems for such institutions. To hedge that risk, the institutions sold Treasury bonds, figuring that if their yields rose, they could be repurchased at a lower price, making up for losses in the mortgage securities.

That just reinforced the slide in Treasury bond prices “like a dog chasing its tail,” said James L. Kochan, a senior vice president of the Strong Funds in Menomonee Falls.

In addition, there is a basic change coming in the price of Treasury securities, as massive deficits mean the government will be borrowing more frequently, increasing supply.

Even so, Kochan is hopeful that the price of Federal securities is ready to settle down after the recent gyrations. At such a time, the last thing the market needs is for the Fed to change rates, especially when no one is expecting it to do so.

Which leaves only this question: How good is Greenspan at flipping burgers?

Contact Avrum D. Lank at (414) 223-5333 or alank@journalsentinel.com.