Bloomberg Columnists 

Bloomberg Columnists

Bond traders were up in arms that a new Fed chief had dared to insinuate a pause in the two-year campaign to normalize short- term rates. which as recently as June 2004 were at 1 percent.
That he should suggest a hiatus with current inflation readings uncomfortably high was not at all acceptable to the bond vigilantes. those guns-for-hire who have been scouring the globe in search of employment opportunities for the last two decades. (Help wanted in Zimbabwe. I hear.)
Bond traders poured out their venom to reporters eager for juicy quotes on how Bumbling Ben was mucking things up. Long-term interest rates rose. market-based measures of inflation expectations deteriorated. and analysts who were in diapers in the '70s talked with furrowed brow about the loss of Fed credibility.
Methinks they protest too much. Fed officials heard their dissatisfaction nevertheless. and pretty soon they were out on the stump. vying for the hawk-of-the-year award.
Over in equity land. a different scenario was unfolding. Investors weren't worried that the Fed was behind the curve; to the contrary. the message emanating from stock prices was that the central bank had already done too much to slow economic growth.
The sell-off since May 11 has been led by cyclical stocks. or shares of companies whose fortunes ebb and flow with the business cycle. In the past month. the Morgan Stanley Cyclical Index has fallen 11.5 percent compared with a 3.4 percent decline in the Morgan Stanley Consumer Index of stable growth companies.
``The underperformance of cyclicals versus staples is the market's way of saying the odds have increased for a more severe slowdown.' says Steven Einhorn. vice chairman of Omega Advisers. ``Bernanke's language' -- the shift to tough anti-inflation rhetoric -- ``has frightened investors into thinking a hard- landing is more of a possibility.' a view Einhorn does not share. (Full disclosure: Einhorn and I have a bet -- and a box of Krispy Kreme donuts -- riding on the degree of the slowdown.)
The bond market has come around to the stock market's way of thinking. albeit via a different. more circuitous route. For anyone who is paying attention -- Fed officials. listen up -- the yield curve is saying. the yield on the 10-year Treasury note quietly slipped below the yield on the funds rate for the first time in more than five years. (I say quietly because there was an outcry when the spread between two- and 10-year notes inverted early this year by a few basis points without producing an immediate recession.)
For those with no sense of economic history. it is not a positive sign for the economy when the policy rate is above the long-term rate. Inverted yield curves -- the depth and duration of the inversion are key -- portend recession.
So reliable has the yield curve been as a leading economic indicator that it was anointed as one of 10 select components in the Index of Leading Economic Indicators.
Stock prices -- specifically the Standard & Poor's 500 Index -- are another leading indicator. The interest rate spread and equity prices. along with the real M2 money supply. comprise the intangible or financial components of the LEI.
Business cycle economists at the Conference Board. keeper of the LEI. claim the financial indicators lead the non-financial ones: things like jobless claims. building permits and capital goods orders.
And guess which is the leadingest of the leaders? which has anticipated the turn in the business cycle by almost a year at the trough and 27 months at the peak on average over the last 50 years. according to the Conference Board.
Whether they realize it or not. the Fed is on the verge of creating a feedback loop that keeps on giving. Consider the following: In talking tough. policy makers have succeeded in lowering long-term rates and reducing inflation expectations as measured by the spread between nominal and inflation-indexed Treasuries. They are now confronted with a pancake-flat yield curve. which threatens to invert if they deliver on their tough talk on June 29 with another 25-basis-point increase in the funds rate.
The flat curve is causing some consternation among stock investors who fear the Fed has gone too far. leading to an exodus from risky assets (emerging markets. for example) and flight into Treasuries. which will invert the curve even more.
The Fed is giving the bond market what it wanted. even as the reflection of those wishes (the long rate below the funds rate) sends the message that the Fed has gone too far.
Policy makers want to be free to choose what they do. In order to gain the confidence of the markets and earn the credibility to do so. they have boxed themselves into a corner.





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