-->07/15/2003
Dow Jones News Services
(Copyright © 2003 Dow Jones & Company, Inc.)



By Michael S. Derby
Of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--Federal Reserve Chairman Alan Greenspan's efforts to play both sides of the fence and win is now over.

The central bank chief and his colleagues on the interest-rate setting Federal Open Market Committee can no longer talk up the economy, while at the same time hint strongly at the possibility of more rate cuts, and expect to keep both stock and bond markets moving upward together.

It's a reality that's been slowing setting in since the end of last month, where a closely-watched Fed meeting failed to deliver what bond traders and investors were looking for, thus sending the Treasury market into a slide that has shown little signs of abating.

Indeed, the selling took up a renewed round of vigor after Greenspan began delivering the first leg of his regular semiannual address on monetary policy to the House of Representatives. While the arc of his testimony pushed much of the same line the Fed has advanced since early May, bond market participants greeted the remarks by smashing yields on long-dated Treasury debt.

Influencing markets with words alone - a practice colloquially known as jawboning - is always a tough and imprecise game, and in the eyes of economists, Greenspan's efforts could only win out for so long. Eventually, the message and monetary policy implications of better growth forecasts, as embodied in sections of the Fed's growth forecasts, would trump bond market hope that the central bank would be forced toward heroic measures to get growth back in gear.


Staying Stimulating

In testimony to and questioning before House Financial Services committee Tuesday, Greenspan laid out a fairly extensive scenario of an economy that's poised to do better, and how the Fed would respond to that. He said"the FOMC stands prepared to maintain a highly accommodative stance of policy for as long as needed to promote satisfactory economic performance."

Greenspan added that more rate cuts could be in the cards, explaining that"with the target funds rate at 1%, substantial further conventional easings could be implemented if the FOMC judged such policy actions warranted."

But those comments came as the Fed made modest trims to its growth estimates for the current year and increased its estimates of growth during 2004.

Perhaps most damning for the bond markets was Greenspan's belief that it will be the federal funds target rate alone that will get the job done."Given the now highly stimulative stance of monetary and fiscal policy and well-anchored inflation expectations, the (FOMC) concluded that economic fundamentals are such that situations requiring special policy actions are most unlikely to arise."

In effect, the Fed chairman signaled that those who were hoping the Fed would substantially ramp up its purchases of long-dated Treasurys in an even more aggressive attempt to stimulate growth won't get what they want. Five- and 10-year notes were sent reeling, up 19 basis points and 20 basis points to 2.74% and 3.93%, respectively. The 10-year note is now well off the record 3.07% yield seen in the middle of last month. The 30-year bond lost over two points and was recently yielding 4.90%.

"There's blood on the floor" in the bond market, said Chris Rupkey, economist with Bank of Tokyo-Mitsubishi, in New York.


End Of An Era

In the minds of many in the market, this rise in long-term yields goes very much against what the Fed has been trying to engineer since its May 6 meeting. Indeed, the higher borrowing costs could be another blow to mortgage refinancing activity just at a tender period in which business spending is seen improving.

The Fed had engineered lower yields by arguing in May that even as the economic outlook had become balanced, that improvement was outweighed by the niggling threat that too slow growth was creating conditions for deflation.

The policy statement supported an ongoing rally in stocks and knocked long-dated Treasury market yields considerably lower. Those conditions persisted until the June 24-25 FOMC meeting, in which the Fed described a similar economic outlook but disappointed markets by lowering rates by a smaller margin than they had expected.

All good things must come to an end, and in the views of economists, it no longer possible for Greenspan to say encouraging things about the economy and keep Treasurys going in a favorable direction. And even with the sell off, some analysts note that the prevailing Treasury market yields are still exceptionally low and supportive of a continuance of cheap borrowing conditions.

"Greenspan had few choices - talk up the economy, remind the markets that rates are low and going to stay that way and gloss over the disinflation/deflation issue which the May FOMC minutes suggested was not as great a concern as some Fed speeches suggested," said Drew Matus, an economist at Lehman Brothers in a note to clients.

Indeed, Greenspan himself seemed to take the back up in bond market yields in stride. In response to a question, he said he was not surprised that the market reacted the way it did after the last FOMC meeting, given that it was priced for a half percentage point interest rate cut.

"We clearly expected that the markets would adjust. How much they would adjust is very difficult to anticipate in advance," Greenspan told the legislators.


(Michael S. Derby writes about markets, the economy and
the Federal Reserve for Dow Jones Newswires.)

-Michael S. Derby, Dow Jones Newswires; 201-938-4192;
michael.derby@dowjones.com

(END) Dow Jones Newswires