Bond Rout Will Push Fed to Tighten

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Low interest rates have shored up the financial system and created a hot housing market over the last two years. But the days of easy money may soon be over, as the Federal Reserve could be forced to quickly correct mistakes it has made in conducting the nation's monetary policy.

Bond market moves and economic statistics strongly suggest that the Federal Reserve will have to raise short-term interest rates far sooner than many investors and economists believe. A hike in short-term rates could cause a selloff in bonds and stocks and a drop in house prices, but failure to act quickly could create even steeper declines.

Fed Chairman Alan Greenspan and other high-ranking officials appear to have committed one of the biggest mistakes in central banking: They lulled the bond market into deeply trusting the central bank and then did many things that were bound to break that trust. The recent rout in the bond market, which has sent yields on the 10-year Treasury bond to 4.23% from 3.07%, is a stark indication of that broken trust.

To win back the respect of markets, the Fed will now have to revert to behaving like a central bank that cares about traditional concerns, such as price stability and the level of the dollar. If Greenspan is in touch with market concerns, expect an increase in the federal funds target rate, currently at a meager 1%, by the end of this year.

So Much Data

So much data indicate that the market believes the Fed is behind the curve. One sign is the difference between the yield on three-month Treasury bills and the yield on 10-year Treasury bonds. When that gap is big, the yield curve is said to be steep. As of Thursday, there was a 3.3-percentage-point difference between the yields on the two bonds, which is a historically wide gap. That spread has increased as longer-term bonds have sold off.

Cash in the Barrel Yield curve spread widens*

*Difference between yields on three-month T-bill and 10-year T-bond. Source: Detox

The simplistic justification for a steep yield curve is that it shows the central bank is keen to see a recovery -- and that a recovery is about to occur. The steepness also excites investors in financial stocks, because banks and brokers can borrow in the short term and invest in longer-term instruments and net easy profits. Indeed, nearly all banks have done that over the last two years -- and the increased steepness of the last two months means even greater profits from this play. And those earnings will help mitigate the capital losses in banks' bond portfolios caused by the recent bond market slump.