It's too soon to say if the bond market will stay on board with the Fed's new world order. From 10 miles up, however, all looks fine, as our chart below suggests. Rates and spreads have both dropped considerably, delivering an upward sloping yield curve along the way. Mr. Bernanke's big adventure, in short, appears to be on track.
After Wednesday's cut, Fed funds were at 3.0%, which is well below the benchmark 10-year Treasury's 3.78% (as of Thursday night's close). The decline and fall of the 10-year yield has been fairly steep and swift. Indeed, the yield at one point last June reached as high as 5.23%. After a subsequent loss of nearly 150-basis points, it's safe to say that a lot's changed.
Surely no one can misread the central bank's new strategy of reflating. That may or may not be the ideal prescription, but a hefty dosage is comine just the same. The rate on Fed funds rarely crumbles this far this quickly. And it's not clear that we're done. The May '08 Fed funds futures contract is priced in anticipation of another 50-basis-point cut, which would bring us down to 2.5%.
So far, the bond market has been happy to tag along with the prevailing monetary winds. This is no small point. One can only imagine the chaos that might erupt if the Fed's aggressive cutting was scaring the heck out of bond investors. In fact, just the opposite has been the norm. One example of the bond market's vote of support can be seen in the 2.8% rise in the iShares Lehman 7-10 Year Treasury ETF (IEF) this month alone. Since last June, this ETF is up about nearly 15%, which, of course, is an extraordinary run for what's essentially a risk-free asset if, and a big if, in a world where inflation is largely mute.
The question is whether the bond market will continue accepting the Fed's reflation efforts? There's always reason to wonder, of course, and all the more so in the wake of recent trading sessions. It's too soon to say if the Treasury market is having second thoughts. On the other hand, the 10-year's yield is 27-basis points higher from January 23's close, when the Fed funds rate was 50 - yes, 50-basis points higher.
In fact, we're reluctant to say that the bullish momentum in Treasuries has run its course. The Fed's still calling the shots and will continue to do so. Or so it seems. But keep in mind that a large share of Treasury owners are foreigners, which is to say investors who live and breath in currencies other than greenbacks. Meanwhile, lower rates in the current economic climate are sure to bring a lower dollar in the forex markets. That, of course, is probably Bernanke and company's goal, at least partly. A weaker dollar will help boost exports, which has been a bright spot for the economy, albeit a weakening bright spot in the fourth quarter.
But how much pain will foreign dollar holders endure? Will they ride the reflation train all the way to the last station? Maybe, maybe not. But as the game of financial chicken rolls on, we're inclined to reallocate money away from domestic bonds into more attractively priced asset classes. No, we don't know when the party will end. In fact, it wouldn't surprise us to watch the good times roll on for months, perhaps through 2009. Much will depend on the degree of weakness in the U.S. economy, and the future path of inflation, all of which will be updated daily, one data point at a time. Fortunately, asset allocation doesn't require dramatic all-or-none, one-day decisions.