THE OTHER IRRATIONAL EXUBERANCE

INTEREST-RATE MOVES WARN THE ECONOMY MAY BE BROKEN (JOHN CRUDELE, August 5, 2003, NY Post)

First, let me say that I hope I'm wrong about this. But the way in which interest rates have behaved over the past month or so should be causing serious concern that the country has gotten itself into a fix that can't be remedied in any conventional way.

Since the Federal Reserve reduced interest rates in early June, the actual rates that people and businesses have to pay to borrow money have soared like a rocket. The interest rate on 30-year government bonds - which are no longer issued by Washington but still trade - has risen from around 4.20 percent to about 5.50 percent.

That has caused 30-year mortgages, for instance, to rise from an average in the very low 5 percent area to over 6 percent.

Why has this happened? That's a good question, and one for which nobody has an answer.

One thing that my sources and I have been worrying about is that foreigners, for a number of reasons, would suddenly find U.S. markets unattractive. If they pulled their money out, rates would automatically rise.

Or rates could be rising because investors think the U.S. Federal Reserve is being irresponsible in its handling of monetary policy. Certainly the federal budget deficit is already high enough to frighten many investors.

All those possibilities are worrisome. But something else is even more tricky: Interest rates could be rising because of the perception that the economy is improving.

Mr. Crudele will be quite relieved to know his initial hope is fulfilled: he IS wrong. Surely he understands the relationships among price, yield, supply and demand in the world of long-term bonds. If not a brief refresher follows:

Remember the price/yield teeter-totter? Yield, in long-term government bonds is a function of price. As the price goes down, the yield (or interest rate) goes up; and vice versa. They're inextricably related. Bonds (from a price standpoint) were on a veritable tear for the (roughly) 12 months prior to about April this year. Accordingly, yields (% rates) spiraled downward as prices rose. If bond prices were equities, Mr. Greenspan could have been making comments about irrational exuberance........but that's another discussion.

Now compound that with supply and demand. When yields (as a function of high prices) on 30-yr bonds get near or even below the average dividend yield of the S&P500, then the implied risk premium of equities dwindles. In other words, at that point, the investor could make as much in dividend interest holding the stock of the 500 largest publicly-traded US companies as could be made in the long bond market.

Giant money managers and enormous pension funds rebalance their asset allocation models usually quarterly. When bonds run up in price and stocks go down in price, what has to happen to re-balance the "slices of pie" in the portfolio? Sell the bonds (creating supply and sending prices lower/yields higher) to buy the equities (creating demand, sending stock prices higher).

The rise in Treasury yields has been led mostly by the intermediate to long-term portion of the yield curve. To no surprise, the 5- to 30-year portion of the yield curve benefited most when the Fed first publicly announced (a few months ago) a minor threat of deflation. Those gains have simply been reversed out and as a result, the yield curve has steepened as 5- to 30-year yields increased while short-term yields remained much more stable. The steeper yield curve actually reflects greater expectations for future economic growth as well as inflation.

As to the boogey man of foreign investors massively dumping US debt in retreat, I've heard there's a US Government that's looking to finance a swelling deficit at the lowest rates it can find. Rolling over some of that older, longer-term, more volatile paper into newer, shorter-term, lower interest stuff (assuming they can continue to find willing buyers) should suit them just fine.

After what we've been through in the last three years, the fear of interest rates being prematurely increased by the Fed in an effort to moderate an overly-exuberant economy is almost laughable. Posted by John Resnick at August 5, 2003 11:37 PM