Alan Cracks Bonds Across the Face

Fed Chairman Greenspan's speech today ratchets up the odds that the FOMC will raise the 5% fed funds target rate again, at its next meeting Aug. 24.
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Keep running, bonds, the



It took one sentence from Federal Reserve Chairman

Alan Greenspan's Humphrey-Hawkins

testimony today to cause the market to beat a fast retreat. Referring to its June 30 interest rate hike, the Fed, Greenspan said, "did not believe that its recent modest tightening would put the risks of inflation going forward completely into balance."

Not quite what the market was expecting. The bond market was looking for even-handed remarks from Greenspan, but today's speech caused a broadbased selloff in the anguished bond market. The speech ratchets up the odds that the Fed will raise the 5% fed funds target rate again, at its next meeting Aug. 24 -- something the market had lately all but stopped sweating.

"Greenspan's remarks did include a number of fairly hawkish comments," said Anthony Karydakis, senior financial economist at

Banc One Capital Markets

. "Those warnings didn't go down well with a market that had come to believe that August was done as an issue."

Caught unaware, the bond market trembled, then disassembled. The 30-year Treasury bond's yield was lately higher by 7 basis points to 5.97%, as the price of the bond fell 25/32 to 90 2/32.

"When they say that the move in June is not enough to balance the risks, what else do you need to know?" asked Tom Ruff, vice president in proprietary trading at

Daiwa Securities


According to others, the market didn't even get that far into the speech (that quote was buried on page six, if you're printing on 8x11 paper) before freaking out.

"Here's the way the events unfolded," said one trader at a primary dealer. "They started running headlines on


, and you'd go, 'bearish, bearish, bearish,' and in the whole string, there was only one you could conceivably call neutral to bullish. You could just look and count up the comments. Everybody was so set up for a benign comment that you didn't have to do any interpretation."

Often, the bond market reverses its knee-jerk reaction to news once closer examination is given. But today, according to four sources, judging the book by its cover was just as good as reading the entire testimony. Even though the Fed chairman spent a good chunk of his testimony before the

House Banking and Financial Services Committee

discussing how productivity improvements have increased growth, sources viewed this speech as among his most hawkish in the last few years.

"Clearly, Greenspan was more hawkish than the market expected, as evidenced in the movement in prices and the flattening in the yield curve," Ruff said. The two-year note, which trades on expectations of where monetary policy is going, fell 5/32 to lift its yield 8 basis points to 5.50%. (The 30-year bond trades on the market's view of where inflation is going -- if the Fed's going to be aggressive in fighting inflation, that's a long-term positive for the 30-year bond, but not short-term securities like the two-year note.)

Another indication of the market's expectations for monetary policy, federal funds futures

traded on the

Chicago Board of Trade

, sold off wildly today. The September fed funds contract, which closed yesterday at 94.915 (corresponding to a funds rate of 5.085%), closed down at 94.915 today (or 5.145%). That's discounting a 58% chance of a rate hike by the beginning of September (logically, the Aug. 24 meeting), compared with yesterday's 34% odds.

"We had become a little complacent about August," said Karydakis, who said he's placing the odds of an August rate hike at 45%. "Greenspan caught the market in the midst of complacency and that's why he did such damage."

What tempered the market's worries about an August rate hike were last week's releases of the

Producer Price Index


Consumer Price Index

, two key pieces of inflationary data. The CPI was unchanged in June for the second month in a row, while the PPI fell by 0.1%. In addition, two Fed officials with little tolerance of inflation risk,

Kansas City Fed


Thomas Hoenig


Richmond Fed


Al Broaddus

, in recent comments have both sounded comfortable with the economy and the inflation outlook.

Suzanne Rizzo, economist at


, doesn't think the Fed will hike rates in August. She cited the rest of that fateful paragraph as evidence. It reads: "However, given the many uncertainties surrounding developments on both the supply and demand side of the economy, the


did not want to foster the impression that it was committed in short order to tighten further. Rather, it judged that it would need to evaluate the incoming data for more signs that further imbalances were likely to develop."

"He said that there's a pretty good chance the Fed might have to tighten again," she said. But August is "still up in the air. He was pretty clear on the point that they do want to wait for more evidence. He didn't want people to get the impression that another rate hike is coming right away."

The chairman will repeat his testimony to the

Senate Banking Committee

next week.