Bonds Reassess Wisdom of Fed Neutrality

For now, the whiff of a Fed sacrificing some of its inflation watchfulness to add to its recession worry was enough to bring the bond vigilantes out of hibernation. Bond vigilantes would argue that yields of longer-duration bonds provide too little reward for the risk associated with the stubbornly high inflation readings that the market has seen of late. In other words, they're not compensated enough for the risk of holding the bond for such a long time if the value of the dollar is going to decline. Vigilantism in the bond market is a far cry from the recession-fear sentiment that has dominated over the past several months.

So within the parameters of remaining on pause, the Fed managed to make a de facto rate cut -- in the eyes of the bond market, at least. The yield curve normalized Wednesday as the short-duration bond yields fell. That trend continued Thursday: The 30-year bond fell 26/32 to yield 4.77%, the 10-year fell 11/32 to yield 4.58%, and the two-year Treasury note fell 3/32 to yield 4.59%.

Wednesday saw banks and the financial sector surge in particular, as the smell of punch grew stronger yet again. The financials didn't continue their rally Thursday, perhaps because the prospect of regulation or government intervention in the mortgage and banking industry looms. Capitol Hill heard testimony of bank regulators and lenders on the extent of potential damage from the subprime mortgage catastrophe. Fed Chairman Ben Bernanke will testify before the Joint Economic Committee on the subprime mortgage market next Wednesday.

If the market has misinterpreted the FOMC's statement, Bernanke will surely let us know. The last time the Fed neared a transition point, in the spring of 2006, Bernanke harshly put the breaks on the notion that the Fed was dovish, in a speech on June 5. The Dow fell 199 points and sparked the second leg of the stock market's downturn that ended in July.