No Shortage of Bubbles and Troubles

The Fed made three points in its Sept. 20 post-meeting statement:

• "The moderation in economic growth appears to be continuing, partly reflecting a cooling of the housing market."
• Moderating energy prices are likely to reduce inflation pressures over time.
• Some inflation risks remain, and additional interest rate increases may be necessary.

The bond market, however, seems to have heard only part of this message, the part about moderating growth and moderating inflationary pressures. Bond investors have been busy bidding up the price of 10-year Treasury notes ever since the last Fed meeting on June 29 in anticipation of exactly this mix of moderate growth and reduced inflationary pressures.

That's why the yield on the 10-year note has sunk to 4.78% at the close on Sept. 20 from 5.22% on June 30. That 8% drop in yield in less than three months is a very strong vote in favor of the success of the Federal Reserve's policies. Bond buyers are willing to accept a lower rate of interest on these long-term notes because they believe that inflation and interest rates will be lower than they are now.

Harder to Avoid Hikes

Of course, the bond market's belief in the Fed's conquest of inflation and in the likelihood of an interest rate cut next year makes it harder for the Fed to avoid raising interest rates. Even with 17 increases in short-term interest rates since June 2004, the Fed has had great difficulty in pushing up long-term rates and interest rates on mortgages that are so often linked to those rates.

Rates on the standard 30-year fixed-rate mortgage didn't climb above 6% to stay until October 2005 -- 15 months and 11 rate hikes after the Fed began to increase short-term rates. And despite all those rate increases from the Fed, the interest rate on a 30-year mortgage had actually climbed only as high as 6.8% by July 2006, shortly after Bernanke and company raised short-term rates for what is, so far, the last time in this cycle.