The Taskmaster - TSC

Return to Article

Greenspan Faces Jilted Treasury Market

Aaron Task

Like Lucy in the classic TV series, Alan Greenspan has some 'splaining to do. The Federal Reserve chairman needs to come clean before the Treasury market, that amorphous yet incredibly powerful body that is increasingly jittery about his intentions.

Day one of Greenspan's two-day congressional testimony presumably didn't go according to plan: Treasury prices plummeted Tuesday, sending yields sharply higher. Stocks also slipped, but their decline was tame compared with a more-than 1-point decline by the benchmark 10-year note and a more than 2-point fall for the 30-year bond. Nonetheless, this increase in long-term bond yields indicates the yield curve is steepening, a classic signal of stronger economic times.

Because most economists foresee solid growth ahead, "he needed to give a speech explaining why deflation is an imminent problem [and] a super-accommodative policy" is appropriate, said Jim Bianco, president of Bianco Research in Chicago. "He failed [to do so], and the bond market had a heart attack," suffering one of its worst one-day point declines since October 1998.

Of course, had Greenspan focused too much on any deflationary threat, the stock market might have suffered a coronary. At this point, the chairman seems more concerned about satisfying his constituents among equities investors vs. those in bond land.

"He is going to try and pull out all the stops to make sure stock investors make money, the economy keeps moving -- and if bond investors lose bucketfuls of money, so be it," Bianco surmised. (Those investors include those who, according to AMG Data Services, plowed more than $133 billion into bond funds in 2002 and another $45.3 billion in the first quarter.)

It's dangerous for the Fed chairman to treat Treasuries like an unwanted child. Although stocks garner most of the public's attention, the fixed-income market is much bigger and has a far greater influence on the broader economy. Most notably, Treasury yields establish lending rates for mortgages and refinancing activity. Anything that unsettles the housing market, the economy's main ballast for the past two years, is likely to frustrate Greenspan's efforts to get the overall economy back on track.

"He wants to see the economy do better, but he just locked the refi door," Bianco said, suggesting higher bond yields will curtail recent record-setting demand for mortgage refinancing.

As discussed in Greenspan's prepared testimony, this is no small matter. Estimated mortgage refinancings, net of cash-outs, exceeded $1.6 trillion in 2002, Greenspan noted. And refinancing activity accelerated from that record pace in the first half of 2003 as rates fell further still -- until very recently that is.

"Households have taken advantage of new lows in mortgage interest rates to refinance debt on more favorable terms, to lengthen debt maturity, and, in many cases, to extract equity from their homes to pay down other higher-cost debt," Greenspan said. "Debt service burdens, accordingly, have declined."

Higher mortgage rates will clearly curtail refinancing activity and also diminish the affordability of home purchases. Either development threatens to undermine strength in the housing sector, which provided a huge boost to overall household wealth in recent years, thus helping consumer spending stay strong despite rising unemployment and sluggish overall growth. Tuesday's stronger-than-expected June retail sales report was the latest evidence of this trend.

On a separate but related note, the S&P Homebuilding Index fell 4.5% Tuesday amid big percentage declines by components such as D.R. Horton (DHI Quote - Cramer on DHI - Stock Picks) and K.B. Home (KBH Quote - Cramer on KBH - Stock Picks). One wonders if this latest backup in bond yields -- and selloff in housing stocks -- will make Berkshire Hathaway's(BRKA Quote - Cramer on BRKA - Stock Picks) $12.50 per share offer more appealing to shareholders of Clayton Homes (CMH Quote - Cramer on CMH - Stock Picks). Several institutions, including Brandywine Asset Management, have expressed opposition to Berkshire's bid; a vote on the offer is scheduled for Wednesday.

Something Borrowed, Something Blue

"What the bond market has essentially done is taken all [Greenspan's] work -- the eases and monetary stimulus -- and canceled it by raising interest rates," Bianco continued. Although bond yields remain low by historic standards, "the bond market has no margin for error," he said. "He's got to talk to the bond guys [Wednesday] and tell them 'my policy is not antibond, won't produce inflation and you guys can start buying bonds again.'"

Unfortunately, Bianco is skeptical that there's anything the chairman can say to placate the Treasury market's new breed of vigilantes. "Then again, I've never understood how you can increase inflation expectations and decrease rates at the same time," he said, referring to the unusual combination Greenspan is trying to create.

As with most things involving Greenspan, there's another side to this story. Tuesday's selloff was mainly focused in long-dated Treasuries because the chairman dampened hopes the Fed would take the unusual step of buying such securities, as had been widely anticipated in recent months. As a result, the yield curve -- or the spread between yields on short- and long-term Treasuries -- widened sharply.

The yield on the benchmark 10-year note settled Tuesday at 3.91%, while the yield on the two-year note was 1.47%. That's the widest gap since November 1992, Bloomberg reported, and compares with a sub-2-point spread as recently as May 23.

Positively sloped yield curves are generally believed to be harbingers of improving economic activity. By contrast, inverted yield curves -- when short-term rates exceed long-term rates -- often presage recessions. Therefore, optimists are likely to be encouraged by Tuesday's Treasury market action and equity bulls relish any and all references to 1992, when the 1990s bull market was in its nascent stage.

Then again, there was tremendous pent-up demand from consumers in the early 1990s and the Internet "revolution" lay ahead. Today, by contrast, corporations are still reeling from the largely misguided spending on online ventures, while the American consumer is mainly satiated after a spending splurge. Notably, that spending was largely facilitated by generational lows in interest rates, something that appears to be reversing in rapid fashion.

Yes indeed, Alan Greenspan will find himself in a tight spot on Capitol Hill Wednesday. Although most equity investors will be focused on Tuesday's barrage of postclose news -- including earnings from Intel (INTC Quote - Cramer on INTC - Stock Picks) and Citigroup's (C Quote - Cramer on C - Stock Picks) offer for Sears' (S Quote - Cramer on S - Stock Picks) credit card business -- rest assured the Treasury market will be listening closely to the chairman.