FOMC Minutes Belie the Threat Posed by Inflation

The number of future hikes 'probably would not be large,' but may be more than bulls expect.
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Wall Street rallied Tuesday after the

Federal Open Market Committee's

Dec. 13 meeting minutes raised hopes that the era of "measured" rate hikes will soon end. The forecast also soothed investors worried about whether last week's yield curve inversions meant an economic slowdown.

The yield curve refers to the upward sloping graph normally created by bond yields in the Treasury market, with yields on shorter-maturity debt typically lower than those on longer maturities to compensate for the fact that it's riskier to lend money for a longer period of time.

An inversion can signal recession because it shows that long-term investors are settling for lower yields now because they think the economy will slow and rates will go even lower.

So when the yield on the two-year note moved above that on the 10-year in late December, economists including John Herrmann, with Cantor Fitzgerald, said the time had come for the Federal Reserve to stop raising the short-term lending rate, which it has pushed to 4.25% from 1% since June 2004.

But Michael Darda, chief economist at MKM Partners, says the yield-curve inversion isn't an accurate predictor of recession because the 10-year note is out of whack. And if the market continues to believe the 10-year yield's false signals and the Fed stops raising short term rates in early 2006, then inflation, not recession, will slam the economy.

A Wayward Note

The benchmark 10-year note has marched to the beat of its own drummer since the central bank began its series of quarter-point rate hikes in June 2004. Since that time, the 10-year yield dropped from 4.61% to about 4.35% in recent trading Wednesday, a decline Fed Chairman Alan Greenspan famously dubbed a "conundrum" in early 2005.

"If you look at the ratio of municipal bonds and the way they measure against all other interest rates, it looks pretty average against them all except for one, the 10-year Treasury," said Hugh Johnson, chairman of Johnson Illington Advisors. "And that yield is far too low."

An ultra-low yield on the 10-year normally would show that bond traders are less worried about inflation because more of them are willing to invest for the long haul.

But outside factors have artificially depressed the benchmark yield, which is used to set key interest rates, including mortgage rates, and Darda said this has led investors to price inflation out of the market too soon.

The stock market fall in 2000 that occurred after the tech bust and wave of accounting scandals artificially bid up the 10-year note in a flight to safety, said Peter Morici, a professor at the University of Maryland's Robert H. Smith School of Business. He added that pension funds have a preference for fixed-income securities, and that long- and medium-note yields will sink only further as the first baby boomers turn 60 this year.

But the role of foreign central banks is the one to watch, said Steve Bohlin, portfolio manager at Thornburg Investment Management.

Foreign central banks in Asia have snapped up the 10-year notes to keep their currency values low relative to the dollar, said Morici. And over the last few years, the U.S. has been a stronger growth engine than Europe and Japan.

Underscoring the point: The Treasury estimates that foreign investors own nearly half of all government bonds, up from less than 35% in 2002. In 2004, foreign investors bought 98.9% of all U.S. Treasury issuance.

"We're mortgaging the economy to investors overseas," says Bohlin, who estimates that foreign buying alone has depressed the 10-year yield by at least 100 basis points.

When that premium is added back in, the curve steepens and there's room for more rate hikes.

How many more?

In a recent paper, Darda observes there is a 300 basis-point gap between nominal GDP, i.e., adjusted for inflation, and the fed funds rate. The 10-year average for the spread is at about 143 basis points, which means that there's about 150 basis points of leeway.

In other words, six more quarter-point rate hikes, which is considerably more than Wall Street is expecting after minutes of the Dec. 13 Fed meeting showed the FOMC believes the number of future interest rate hikes "probably would not be large."

Alternate Inflation Signals

Darda believes the "one and done" crowd is in for a nasty surprise, noting other key barometers beyond the GDP-fed funds gap show an excess of liquidity, namely sky-high precious metals prices and the fact that business loans are expanding at a 12.9% annual rate.

"Core inflation is still low, but the rising cost of fuel and food will show up in the core rate over the next two years because we do eat and drive," he added.

If inflation does take Wall Street by surprise, it leaves the economy vulnerable in two ways. For starters, investors might jump off the 10-year bandwagon in a hurry, causing a rapid rise on the back end of the curve.

Many economists believe there will be a slowdown in housing-market growth, but not contraction. That could change if long bonds sell off sharply, because mortgages track the movement of the 10-year yield.

"Consumers already got the heating bill to deal with," said Thornburg's Bohlin. "Do they really need to think about the housing market shutting down and shutting down their discretionary buying?"

An inflation spike also could scare foreign investors away from U.S. debt because inflation eats away at the value of fixed-income investments. Why buy Treasuries if it looks like there are better values to be had in the equity markets or in other government bonds?

Less-enthusiastic buying of Treasuries would have profoundly negative implications for the U.S. economy, given the nation's budget deficit is currently being funded by foreigners buying our debt. If that happens, people will have a hard time remembering why they were so euphoric on the first trading day of 2006.