Fed Watch: When Will Rates Be Raised?

Fed to Touch Extension Chord

by Randall W. Forsyth
Friday, June 18, 2010provided by

 

The central bank is likely to maintain low rates for an even longer "extended period" than expected. Good news for Treasuries. 

Fed watchers may as well take next Wednesday off. Even though the Federal Open Market Committee will wrap up its two-day policy meeting that day, they aren't likely to have much new to scrutinize. So, they can take in a round of golf or a matinee and not be missed.
In part, that's because any mystery about the Federal Reserve's plans for its near-term monetary policy has been all but erased by events and news leaks. In the case of the latter, the page one lead story in Tuesday's Wall Street Journal reported Fed officials were mulling what steps to take if the economy stumbles or inflation diminishes further.



At recent FOMC meetings, the policy-setting panel has maintained the status quo of a federal-funds target of 0-0.25% and holding policy interest rates at low levels "for an extended period." But the question always was when that extended period would expire.


Indeed, Kansas City Fed President Thomas Hoenig dissented at the past three meetings because the "extended period" language appeared to shackle the Fed should an interest-rate increase be needed sooner rather than later.


That no longer seems to be a concern. The Journal's story wasn't attributed to any Fed official and therefore is likely to be on the highest authority; otherwise the Journal's editors wouldn't have run it. While Fed Chairman Ben Bernanke is sticking to the central bank's forecast that the recovery is on track, the story makes clear the Fed is hedging its bets.
In that, the monetary authorities merely are acknowledging the signal the Treasury market has been sending for the past month and a half. Growth appears to be faltering while inflation is receding further, as indicated by the slide in the benchmark 10-year Treasury note yield from 4% to a low of 3.15% last month. Since then, the yield has backed up a bit to 3.25%.


In the process, expectations about the course of interest rates have been racheted lower. In terms of the fed-funds rate, a recent paper by Glenn D. Rudebusch, economist with the San Francisco Fed, estimates on the basis of the central bank's response to inflation and unemployment, the key policy rate would be negative 5%, were that possible. Based on this model, the fed-funds rate target gets back to nil only in 2012.


As result, the forecast for interest rates has moved to lower, longer. For instance, the Royal Bank of Scotland made a large, downward revision in its outlook for U.S. rates -- even with continuing economic recovery. RBS's reasons for its changes are enlightening.


While most observers agree the European credit crisis shouldn't hit the U.S. economy too hard, RBS thinks "the latent threat to global financial stability" isn't fully reflected in U.S. bond yields. The 20% plunge in the euro leaves U.S. assets as the main safe haven for the world's liquid assets.


Even before global demand for Treasuries was being boosted by the European crisis, RBS pointed to steady buying by U.S. households, commercial banks and foreign investors. Even if lower yields deter buying by Main Street USA, RBS doesn't think the trend will reverse.


Overseas investors have their fingers on the trigger to buy if yields move up from the current 3.25%, according to RBS's client contacts. Investors who have missed a rally always want a market correction to give them a buying opportunity, and that seems to describe the attitude of lots of non-U.S. participants.


Moreover, the diversification out of U.S. dollar assets appears to have run its course, RBS also notes. Seven months ago, everybody hated the greenback. The "Demise of the Dollar" was certain, especially among British publications. This column thought the piling on was overdone. In that time, the U.S. Dollar Index is up abut 15%, largely because of the slide in the euro, the putative substitute for the dollar.


RBS thinks U.S. fiscal trends will be supportive of the Treasury market, not its demise, as mega-bears insist. Europe's debt crisis will put the fear of God into Americans to get their fiscal houses in order, the bank suggests. Invoking Keynesian notions, RBS thinks that tax hikes won't derail a recovery because the rich have a lower propensity to spend. That leaves higher earners less to save and invest in businesses that might hire some folks. But that's an argument for another day.


Taking it all together, RBS sees the benchmark 10-year Treasury yield dropping below 3% in the second half of the year. The 30-year bond yield is forecast to dip under 4%, from 4.18% Wednesday.


In the current investment environment, there are lots of things to worry about. Higher U.S. inflation and Treasury yields aren't among them.

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