The stock market may steal the headlines, but in many ways its the bond market — be it mortgage-backed securities, government bonds, or corporate debt — that is the real star of the economic show. When the Federal Reserve seeks to regulate the economy, it does so by involving itself in the bond market, through buying and selling government debt and mortgage-backed securities. For years now, the Fed has been in the practice of buying bonds in order to keep interest rates low, which boosts the economy by making it cheaper for corporations and individuals to borrow. The indirect effect of low interest rates is higher stock and home values, but it’s always interest rates, rather than asset values, that the Fed watches most closely.
And for several weeks now, and especially since Ben Bernanke’s press conference last Wednesday, interest rates have been rising quickly on everything from corporate debt to mortgages. (The average 30-year mortgages hit a two-year high of 4.46% on Thursday.) In fact, many observers are now worried that spiking rates will put a damper on the already anemic U.S. economic recovery. Economists from Goldman Sachs estimate that recent rate increases could shave as much as 0.4% from growth over the next year.
Yesterday the central bank sent one of its most influential members, New York Fed President William Dudley, to try to calm markets in a press briefing. Dudley addressed fears that the Fed’s announcement last week that it would likely begin “tapering” its bond-buying program later this year would mean that it would also raise short-term interest rates. Said Dudley: “Let me emphasize that such an expectation would be quite out of sync with both FOMC statements and the expectations of most FOMC participants.”
In other words, Dudley is accusing the market of simply misunderstanding the Fed. Sure,the Fed may have announced that it would pull back on bond purchases later this year if economic conditions warrant, but that would be a very gradual process and shouldn’t warrant a rise in short-term interest rates any time soon.
So why are investors bidding up interest rates anyway? After all, the Federal Reserve has the ability and the willingness to do whatever it takes to keep rates low — and Fed officials from Bernanke to Dudley have been at pains to stress their desire to keep rates low for at least a couple more years. Part of the answer to this mystery is that markets aren’t always rational, and a Fed exit from a bond buying program is an unprecedented situation. So owners of all sorts of debt may simply be worried about being heavily invested in markets that could behave unpredictably in the future. Bonds have had a good run the past several years, so why not get out now before the Fed does finally move to raise rates?
If that’s what’s going on, however, it reveals a major flaw in the Federal Reserve’s efforts to exert control over market expectations. Since the crisis, Ben Bernanke has used statements and promises to help goose the economic recovery. The theory is that if the Fed not only lowers rates, but convinces consumers and businesses that rates will remain low long into the future, they’ll be more likely to make decisions that will support the economy. But playing with expectations is a dangerous game. After all, the future is uncertain, even for the all-powerful Federal Reserve. Investors aren’t so much “fighting the Fed,” as the famous maxim warns against, as trying to get out ahead of an inevitable wind-down. After all, if there’s anything the Fed has made more clear than its desire to keep interest rates low, it’s that it eventually plans to raise them again.
The difficult tight-rope the Fed must walk is to both communicate the winding down of its stimulus effectively to the market, while making it clear that its support will continue as needed. In order to maintain that balance, the Fed isn’t likely to overreact to just one or two weeks’ worth of data. So if interest rates continue to rise, expect more Fed officials to be trotted out to assure markets that rates are not going up anytime soon.
The great unknown is whether rates will rise high enough to seriously impede economic growth. If that’s the case, the Fed has promised to step in with even more bond purchases — a move which could blow up in the faces of the very investors fleeing the bond markets now.