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The Fed Changes the Formula

Bernanke's glasnost keeps traders guessing on the next rate cut.

The bond market may have taken in a tiny dose of religion Thursday. A couple of


speakers attempted to preach it, at least.

After Federal Reserve Chairman Ben Bernanke's speech to the Economic Club of Washington was interpreted by the Treasury bond market as more evidence that the Fed will cut rates sooner rather than later, Fed Vice Chairman Donald Kohn played bad cop Wednesday evening in a speech to the Money Marketeers of New York University. Kohn emphasized the economy's strength and the risks of inflation.

Newly installed Philadelphia Fed President Charles Plosser followed up Thursday by reiterating that inflation is the "predominant risk" to the current economy. This is hardly the formula for a rate cut.

If the bond market was waiting for Bernanke to chastise its negative bet on the economy, it was Kohn that did just that. But bond traders are still weaning off Greenspan, so the vice chairman's words pack less of a punch than they would coming from Bernanke's mouth. Kohn said he was "surprised at how little market participants seem to share my sense that the uncertainties around these (growth and inflation) paths and their implications for the stance of policy are fairly sizeable at this point, judging by the very low level of implied volatilities in the interest rate markets."

Cue the selloff in Treasuries, which have rallied through the summer to leave long-term interest rates hovering 75 basis points beneath the fed funds borrowing rate. The Treasury market reacted by selling off a bit Thursday but retained its pessimistic bias. The 10-year Treasury bond lost 11/32 in price to yield 4.61%, while the 30-year bond lost 19/32 to yield 4.76%, and the five-year note fell 8/32 to yield 4.54%.

The bond market's summer rally reveals a deep-seated pessimism, as valuations are historically low relative to headline and core inflation, GDP growth, and to stock market yields.

"You have dire expectations priced into bonds," says Michael Darda, chief economist at MKM Partners, adding that Kohn's speech was on target. "This is like watching tech stocks in late 1999 where valuations were out of line with fundamentals, and those that warned against it got tired because it had gone on so long ... I'm afraid that the same kind of wild-eyed optimism has gripped the Treasury market."

On the bull side for bonds, you have dismal housing data and the inverted yield curve, which historically predates an economic recession or significant slowdown.

On the side of no recession -- and no rate cuts -- you have several factors. Kohn outlined them best Wednesday night: "Financial conditions remain quite supportive of borrowing and spending," he said. "Market interest rates are not high in nominal or real terms; credit spreads are narrow and equity prices continue to rise, conditions that keep the cost of business finance down and suggest investor confidence in the future course of the economy."

That list doesn't even include the recent correction in energy prices, which also stimulate economic activity and consumer spending. Additionally, there is early evidence in the form of rising mortgage applications, that the housing market correction may be nearing its bottom.

"Remind me why the economy is so bad?" quips James Bianco, head of Bianco Research.

The newest factor flying in the face of overvalued bonds is the soaring stock market, says Bianco. The bond bulls (read: economy bears) say that stock prices will come down. "If that doesn't happen, at some point, the stock market's levels become problematic for the bond bulls, too," says Bianco.


Dow Jones Industrial Average

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kept going up Thursday. The Dow ended the day up 0.1% to close at 11,866.69, while the

S&P 500

gained 0.2% to close at 1353.22, and the

Nasdaq Composite

finished up 0.67% to close at 2306.34.

Lower gasoline prices meant consumers were spending in September as back-to-school sales were stronger than expected. Retail Metrics' index of same-store sales climbed 3.8% in September, and 6% if you exclude a disappointing report from


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The Standard & Poor's Retail Index climbed 0.15% on the day. Shares of large retailers


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gained 1.82% and 0.55%, respectively, while specialty stores like

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gained 4.66%.

Wal-Mart shot itself in the foot Thursday, saying same-store sales climbed 1.3% for the month, after announcing a 1.8% jump over the past weekend. The company cited a miscalculation as reason for the drop -- a costly miscalculation indeed, as Wal-Mart's shares fell 2.3%.

Leading the Dow to its third new high in a row were shares of


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, which gained 4.12% and 1.95%, respectively. The index was more mixed Thursday, with 17 out of its 30 stocks declining.

Communication Overhaul

Despite not coming from the lips of Bernanke, the speeches from Kohn and Plosser actually carry more weight, given the new Fed chairman's communication style, which tends toward 'glasnost,' says Bianco.

After accidentally giving the scoop of the year to


Maria Bartiromo this spring, Bernanke vowed to speak only through official channels. And a midsummer

Wall Street Journal

profile outlined his democratic method for running meetings -- giving the Fed governors and presidents more freedom to express their opinions as he takes a backseat as the committee's steward.

In this context, Richmond Fed President and FOMC member Jeffrey Lacker's dissent at the last meeting against maintaining rates isn't so outlandish. Indeed, some expect that St. Louis Fed President William Poole could also become a dissenter when he joins the committee this month. Bond traders are still having trouble getting used to the new openness after the Greenspan-led unanimous Fed.

But what if Bernanke ran the Fed like the Supreme Court, with 7-5 votes on rate moves? wonders Bianco. The bond market could easily be off the mark in its certainty if the FOMC is so uncertain.

The fed funds futures market has essentially priced in no movement from the Fed at the October and December meetings. So, the recent hawkish talk from the Fed is giving the bond market a nudge, but bond traders have time to digest the message. "We're playing for the January and March meetings," says Bianco.

So, don't expect a 1987 for the bond market just yet -- even if payrolls data is weak Friday, or even if the CPI is high this month or next. Religion is not begotten in a day.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click


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