Fed Watch: San Francisco Fed Paper Makes Sense Of Bond Yields

By: Michael S. Derby

Publication date: May 27, 2005

Published in: Dow Jones Newswires

NEW YORK (Dow Jones)--One of the great dilemmas of the Federal Reserve's almost year old rate hike campaign is the broad-based fear that the bond market has failed to reflect the tightening.

After all, long-term bond yields, which should be rising by most analysts' reckoning, are now well below where they were when the Fed began raising the key federal funds rate at the end of June, 2004.

Fed Chairman Alan Greenspan, back in February, called this a 'conundrum' for which he has no truly compelling explanation. Other central bankers, when pressed, suggest that yields probably reflect the market's confidence that the Fed will keep inflation in check, even as many investors fret openly about rising inflation pressures. Meanwhile, observers worry that if markets pass on tighter monetary policy, the Fed's one tool to control the economy may be broken.

A researcher with the San Francisco Fed says in a new note that against the current climate of consternation, everything is in fact working just as it should be.

Visiting scholar and University of California Davis Professor Oscar Jorda writes in the regional Fed's latest Economic Letter that the relationship between changes in the fed funds target rate and the shape of the bond yield curve, which tracks relationships between securities of different maturities, can be boiled down to a relatively simple, yet effective, formula. By using the equation, a 10-year note yielding just over 4% now doesn't look so strange.

Jorda writes that going back to 1984, gradual changes in monetary policy, like the ones that have defined the current tightening cycle, are generally the rule. Over this period through to March of this year, 'a crude average ..suggests that once a new policy direction is taken, the Fed will increase - or lower - this target by 3.75% over the span of two years at a rate of 0.165% per month.' That amounts to around a quarter percentage point move per Federal Open Market Committee meeting, which come at roughly six week intervals.

That 3.75%, when applied to the tightening cycle that began last June, suggests the Fed will end up at 4.75% by June 2006, given the 1% fed funds rate last June. Jorda, noting a rational yield curve's returns show longer yields as averages of shorter term yields, found that the implied yield curve suggested by his rule very closely matched where the U.S. government bond curve was when the tightening cycle began last year.

Does Move Long End

'The Fed does influence long-term rates significantly,' Jorda wrote. And echoing the view of some policy makers, he added, 'the absence of significant premiums on longer-term Treasuries is a public vote of confidence on the Fed's stewardship of its control of inflation in the long run.'

Jorda, in an interview, said that his 3.75% rule is only meant to serve as a 'back of the envelope' tool. It doesn't try to capture factors like the influence of central bank buying in government bonds or other forces that can influence yields, he said.

For the economist, the fact that the 10-year yield may be lower now than when the Fed started raising rates last year isn't surprising. That's in large part because as long as the economic story stays the same - through the cycle, U.S. growth has been largely steady and close to trend, and the Fed steadfast in its outlook for rates - it's natural for spreads between short and long dated yields to narrow a bit.

'If there are no new developments in the economy, the curve should flatten,' Jorda said. And that's just what's happened. 'The big trends in bond yields seem to be well captured' by the 3.75% rule, Jorda concluded.