Today's jack-in-the-box intermeeting move by the
Federal Reserve sent stocks soaring, natch. But if you want a better crystal ball -- or at least a magic 8 ball -- to tell you what the future might hold, you might want to check the bond market. Your answer: Our sources say improving economy and at least one more rate cut.
Indeed, movements in the bond market offer a prediction for the economy and where it is headed. In the past, a positive sloping yield curve -- that is, you get a higher yield for a longer-dated security -- was an indication of economic growth to come. An inverted yield curve, which the market was facing through March of this year, was bad news, as it's been a reasonably accurate predictor of a recession, or at least a nasty downturn.
yield curve refers to the difference in yield between two Treasury securities of varying maturity. An investor usually assumes greater risk on a longer-dated security because there's more uncertainty about what might happen 30 years down the road than in three months.
So, an upward sloping yield curve indicating that investors accept lower yields on shorter-term maturities means that the economy could be headed for near-term growth and things will soon improve. On the flip side, when investors demand a higher yield for shorter-term securities, they feel there's a greater risk in coming months. This can then be a sign of belt-tightening times to come.
The yield curve started on a positive trek earlier this year as shorter maturities yielded less than longer maturities. The catalyst back then was the Fed's intermeeting cut on Jan 3. Today, Alan Greenspan & Co. cut the fed funds rate to 4.5% from 5%. And lo and behold, shorter-term maturities rallied while the longer-term securities, such as the 30-year bond, sold off, steepening the upward sloping yield curve.
The two-year note, which is affected most directly by expected changes in monetary policy, saw the sharpest rally today, continuing a recent trend of steepening in the curve. In late afternoon trading, it rose 8/32 to 99 31/32, lowering the yield to 4.266%. The 10-year benchmark note, after initially losing ground following the cut, recently gained 24/32 to 99 1/32, moving the yield down to 5.128%. The 30-year bond, which also traded off earlier today, was recently higher by 7/32 to 96 2/32, yielding 5.649%.
According to John Lonski, senior economist at
Moody's Investors Service
, the yield curve charting the difference between short and long term maturities accurately predicted the performance of the economy in the past. In late 1998, everyone was betting on a gloomy economic forecast, but the rising yield curve "correctly foresaw what would be a good economy in 1999," Lonski said. "So, today's steepening of the yield curve reflects how investors are more convinced that the U.S. economy will regain momentum this year."
Lonski also believes that the steepening of the yield curve, due to the rise of the two-year note, suggests the market is looking for another interest rate cut when it meets on May 15.
Surprise, Surprise, Surprise!
Make no mistake, the bond market wasn't exactly expecting the Fed to make an intermeeting move today.
"I am totally surprised by this," said Maryann Hurley at
. "The bond market had pretty much ruled out an intermeeting rate cut from the Fed. And they did a 50 basis point, which is a significant action. I'm guessing that they are seeing a continued severe slowdown in the economy and that waiting on the May 15 FOMC meeting was just too long. I'm concerned about what they see and what we don't see."
Bill Hornbarger, market strategist at
A.G. Edwards & Sons
said the "sneaky, sneaky Fed" consistently led the market to believe that there would be no inter-meeting move and that the yield curve had recently started to flatten -- that is, the difference in basis points between the short end and long end started to decline. That reflects the expectation that such a cut wasn't going to happen, and it occured in no small part because Fed officials have been out en masse in recent weeks, suggesting that they'd rather not cut rates in-between meetings.
A nice two-week stock rally here, and a halfway-decent report on industrial production there, and everyone was a believer. "
The Fed caught everybody leaning the wrong way in the bond market," Hornbarger said, noting that today's volatility in the bond market will take a couple of days to settle.
But by and large, today's "pro-growth message by the Fed" has convinced the bond market that growth and economic recovery is on its way. Dana Johnson, treasury market strategist at
Banc One Capital Markets
expects the curve to continue its steep climb, particularly if the Fed eases again in mid May.
And if the rally in stocks sticks, the steepening trend in the bond market will continue further. The rise in stocks would be expected to boost spending and demand for credit, and long-dated yields would likely move higher, Johnson said.
"I think that the bond market will still be expecting more to come," D.A. Davidson's Hurley said. "Given the positive reaction we've seen from the equity market, this may be what the economy needs to put it on its feet again."