The Fed’s true goal

Any rescue of the stock market, let alone global markets, was never the Fed’s first goal — even if the Monday crisis did influence its timing. Its real goal is to keep longerterm rates at a yield that represents good value to global investors.

Stock market meltdowns are bad for bonds in this regard. Flight capital raises prices and depresses yield. From a peak of 5.251 percent last June 14, the yield on the 10-year T-note sank to less than 3.25 percent on Jan. 22 as the global stock market crisis unfolded. Because the fed funds rate was at 4.25 percent at the time, this represented a special type of yieldcurve inversion. Even after the Fed cut rates 75 bp, the fed funds was still yielding more than the 10-year Tnote.

Equally important, headline CPI inflation in November was 4.1 percent. The implication is the 10-year bond is delivering a negative real return, with “real” meaning “after inflation”. The all time Treasury-yield low is 3.083 percent from June 2003. The correlation between yield and the dollar index is far from perfect—you get a better correlation using the yield differential with the German Bund, for which data is not readily available. But the connection is pretty clear: The dollar falls as yield falls. Bond traders call that a rally because as yield falls, prices rise. However, if you are a foreign investor — and the U.S. depends increasingly on foreign investors in Treasuries — you may be gaining with one hand (bond price) but losing with the other (currency level).

Just as we cannot expect a stock market decline to stop on a dime, we can’t expect a bond market rally to stop on a dime, either.

Bond yields stop falling when several conditions are met. First, the recession has actually arrived and its end is in sight. Second, the central bank is perceived as having reached the lowest short-term rate it will tolerate. Third, inflation fear overcomes recession fear.

Because the financial sector has a long way to go to disclose all the ugly news about losses on badly packaged and improperly rated debt, we can’t expect an end to the stock market drop and the bond market rally until the end of the first quarter after all companies have reported. And since we can’t trust what financial institutions are telling us, the end probably will not come until the end of the second quarter (June).

We should assume the Fed wants the 10-year bond yield to reflect a basic rate of return, historically 2.5 percent, plus a premium for expected future inflation, say 2.70 (based on the TIPS spread with regular Treasuries), or 5.1 percent. When the actual yield is down around 3-3.25 percent, the only reason for foreign investors to buy U.S. paper is fear that other paper (such as foreign stocks) is worse. This is not a healthy reason to be on the receiving end of foreign capital inflows, and it opens the U.S. to a charge of “manipulating” global capital markets even though the Fed has no actual control over anything other than short-term rates.

Critics are sure to say the Fed was in panic mode by cutting 75 bp on an inter-meeting basis. But in light of its true goal of lightening the inflow to Treasuries, and thus preventing the yield from falling to ridiculous (and unsustainable) low levels, it was doing the world — and the dollar — a favor.