Interest Rate Roundup

Wednesday, January 31, 2007

Some more thoughts on the Fed's stance

Well, there you have it -- no bearish Fed "hand grenades" = big rally in bonds. Bonds finished the day up 20/32, while 10-year note yields dropped 4.5 basis points to 4.82%.

Here’s the biggest problem, as I see it: There has been a gigantic, easy money fueled rally in the asset markets lately. Risk appetites are very high. The spreads, or differences, between yields on higher-risk bonds and loans and yields on low-risk Treasuries are very small when compared to historical averages. Commercial real estate values are going through the roof. Stocks are on fire.

Fed officials have stated that they will basically ignore any inflation in the asset markets, and focus on the "real" economy instead. But with money supply surging and risk-taking running rampant, that approach doesn’t make sense. Other central bankers – most notably in Europe – pay close attention to money supply and asset prices. If the Fed continues to keep the monetary taps wide open, we could end up with even more "new" bubbles to replace the one that just burst in housing.

Another key risk: The dollar. The recent rise in interest rates helped take the pressure off the greenback. But the dollar is slipping in the wake of this Fed news. That, in turn, is causing some reflation in commodity prices – oil shot up more than a dollar today, while gold rallied strongly. The end result: Inflation pressures could build right back up again. Indeed, a market-based indicator of inflation known as the TIPS spread is at its highest level since September.


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