Despite the steady drumbeat of caution coming from
Federal Reserve officials, markets continue to adhere to the notion that interest rates will rise sharply over the course of the year.
Fed funds futures, traded at the Chicago Board of Trade, imply a
fed funds target rate of at least 2% by midyear, up from the current 1.75%. The December eurodollar contract implies a funds rate of 3.5% by year-end. Meantime, longer-term bond yields, like the benchmark 10-year Treasury, are well above the current funds rate, reflecting a belief that the Fed will soon be putting on the screws.
The chatter from members of the
Federal Open Market Committee suggests that rates may not go up so soon. Monday, Atlanta Fed President Jack Guynn said "it would be premature" to say the economy has bottomed. Tuesday, Philadelphia Fed President Anthony Santomero said that he didn't think the economy would rebound until "around mid-2002 -- a few months later than the median forecast predicts." Today, Dallas Fed President Bob McTeer said that the economic data had moved to "mixed" and that inflation wasn't going to be a problem.
Everybody is waiting for Fed Chairman
Alan Greenspan to give his semi-annual report to Congress on Friday (what used to be called the Humphrey-Hawkins testimony), but given what's already been said, it seems a good bet that he'll strike a more cautious note on the economy than what you'd glean from markets.
"It's a pretty unified message" coming out of the Fed, says Fuji Futures chief strategist John Vail. "It's not all coming from the same script, but it's pretty unified." Vail thinks that Fed officials' caution shows they're worried about long-term bond yields going any higher, which in itself could mute, or potentially even quash, the economy's recovery.
A glance at the history book reinforces the notion the Fed won't be quick to raise rates. International Strategy & Investment Group political strategist Tom Gallagher points out that in the postwar period, the Fed has never hiked rates until after the unemployment rate peaked -- it would be politically difficult to raise rates in the midst of job losses. To add to that, as well as things have gone in Afghanistan, the U.S. remains on a war footing. Keeping rates low -- in effect, taking an insurance policy out on the economy -- makes some sense.
"The market is expecting too much tightening this year," says Tony Crescenzi, bond market strategist at Miller Tabak. He thinks that for the Fed to hike rates aggressively, it would have to first see the economy growing above potential -- say more than 3% -- for a prolonged period. Crescenzi is bullish on the economy, but not that bullish.
But Morgan Stanley chief U.S. fixed-income economist David Greenlaw makes the case that rates will rise this year just as sharply as the market thinks. Just because the Fed has tended to be slow at moving rates higher coming out of a recession doesn't mean that will be the case this time around. "One of the reasons they'll tighten is the lessons they've learned," he says. "They don't want to make the mistakes they made in the 1970s and 1980s. They recognize that historically they've dragged their feet."
In truth, it's probably foot-dragging that bond investors are most worried about -- and the reason that yields have remained persistently high. Both the stock and fixed-income markets have been predicting a quicker recovery than most professional forecasters have reckoned, and the strength of recent economic data suggests to some that the markets have got it right.
Oddly enough, if the Federal Open Market Committee really wants to see long yields go lower, it won't drop rates for a 12th time when it meets Jan. 30-31. That's not what most Wall Street economists expect -- a recent
poll showed 19 of 24 expect another quarter-point cut. Come the end of the month, the Fed watchers might be in for a surprise.