LONG BOND CONUNDRUM

Comstock Partners, Inc.
Low Bond Rates Mean Ever Higher Funds Rate
August 04, 2005

An important, but largely overlooked article by Greg Ip in yesterday’s Wall Street Journal clearly signals the Fed’s intentions to keep raising the fed funds rate until the long-rate increases sharply as well. In our view this can have only negative consequences for both the stock market and the economy.

Greg Ip is known to be a conduit through whom the Fed communicates with the public, and he states at the beginning of the article that “officials there increasingly believe…”. It is obvious from the tone that the reporter was given an off-the-record interview with one or more Fed officials, most likely including Greenspan himself. This would be in keeping with prior periods when it was well known that the Fed used the Journal, the New York Times and John Berry, formerly of the Washington Post, to disseminate views that they did not want to state for attribution.

The article states that the bond market in keeping long rates low was diluting Fed “efforts to tighten credit and contain inflation. The result: The longer the bond market keeps long-term rates unusually low, the further the Fed is likely to raise the short term rates…” According to former Fed governor Laurence Meyer, low bond yields “are telling the Fed its job isn’t done and they have to keep going.”

It is clear from prior statements, however, that it's not economic overheating and inflation that the Fed is worried about—it is housing prices. Over the past few months words and actions by the Fed and other financial institutions strongly indicate they are more worried than they say about the bubbling housing market, and the low yield on the long-term bond is a primary culprit. In mid-May the Fed and a number of other agencies, in a try at moral suasion, issued new guidance to mortgage lenders in an attempt to dampen a number of speculative practices that were contributing to the bubble.

In addition Greenspan’s congressional testimony and speeches by other Fed governors have devoted an increasing portion of space to the “froth” in local markets. They obviously must be aware that these “local” markets include the Northeast seaboard, Florida, and California as well as many other points inland as our emails will attest. These areas comprise a huge portion of the U.S. population and total national home values. It is also these same areas that have provided the mortgage refinancing cash-outs amounting to hundreds of billions of dollars that have helped keep consumer spending afloat and the savings rate close to zero. In Greenspan’s congressional testimony on July 21 he directly attributed the boom in home prices and associated risks to the unusual drop in long-rates in the face of an increase in the fed funds rate.

In our view the Fed is walking a fine line. They recognize that they must do something about the bubbling housing market, yet run the risk of going too far and throwing the economy into recession and the stock market into a deep downtrend. Since the start of the Fed in 1913 they have instituted a policy of monetary restraint 15 times prior to this one, and in the vast majority of cases, stocks have declined significantly and the economy has gone into recession. With the current economic expansion so unbalanced, growth so dependent on housing, and consumer debt at record levels, the chances of the economy getting out of this mess unscathed look exceedingly small—and this is without even considering the high level of oil prices and the record trade imbalance.

**Also from FRI and SAT Greenspan comments, this appears to be true.

D