Being Alan Greenspan

By Scott Lummer
Chief Investment Officer, mPower

Technical Terms Bond Federal Reserve Board NASDAQ

The question of the week is:

"I'm confused as to how the Fed's decrease in interest rates is affecting bond values. It seems like Treasuries have lost value since the Fed action in early January 2001. What can reasonably be expected for bonds the rest of 2001?"

Let's first look at what happened. On Jan. 3, the Federal Reserve Board cut interest rates from 6.5 percent to 6.0 percent. The move took the capital markets by surprise; in part because it didn't happen during a scheduled meeting, which is when the Fed would usually make such cuts. It could actually be considered to have been an emergency measure to bolster the economy. Most analysts perceive that there will be another cut during the regularly scheduled meeting later this month.

Over the past several months, equity market analysts have indicated growing concern about whether last year's rate increases may have slowed down the economy more than the Fed intended. Indeed, there are concerns about whether we might be headed for a recession. (If I seem overly critical, it's because I had a television appearance on Jan. 3 that was drastically scaled back because of the Fed news. I hate getting pre-empted.) The stock market responded very favorably to the news of the cut, although it could be said that the 14 percent jump in the NASDAQ was an overreaction.

Over the past few years, Fed Chairman Alan Greenspan has seemed to be able to wave a magic wand and set monetary policy to allow reasonable growth with low inflation. Is his magic wand finally running out of steam? The interest rate increases last year may have been too high and too fast. (Hey, here's a cool movie plot. A puppeteer finds a secret passageway into the mind of a Federal Reserve Chairman, buys many put options, and fiendishly starts wreaking havoc with the U.S. stock market.)

What About Bonds?

The reader seems confused about the effect the interest rate cuts had on bond values. This is understandable. If the Fed ordered a decrease in short-term interest rates, it seems logical that this would cause longer-term rates to drop as well, which in turn would cause bond values to rise (remember, there is an inverse relationship between market interest rates and bond values).

However, a cut in short-term rates could lead to inflation over the long term, which would cause bond values to fall. Still, in my opinion, this is not the reason why bond prices fell after the Fed cuts either.

Usually the bond market is impacted by either expectations of future inflation or other national or international monetary factors. However, lately the market has been driven by basic demand. The demand for one security compared to the demand for another is something that impacts all prices in the market. Many investors who didn't want to invest in the stock market in the second half of last year put their money in bonds instead. That is why the bond market did very well during 2000. When the Fed cut rates, however, many investors wanted to come back into the stock market. To purchase stocks, many of those investors sold bonds, which caused the prices to fall. So, it wasn't the rate cut by itself that hurt bonds. The rate cut increased stock values, which for a short time were competing with bonds for investors' attention.

The Bond Outlook

Related Reading Wall Street 101: Stocks, Bonds and Basics Shake Your Bond-bond A Simple Plan

What can be expected in 2001? In my opinion, while bonds can play an important role in a diversified portfolio, one should never invest in bonds with the expectation of large capital gains. There are years when interest rates will increase and cause prices to fall. And, there will be years like last year when the reverse occurred. However, I think it would be a mistake for an investor — particularly one with long-term goals — to invest in bonds hoping for short-term gains. The yield on short-term bonds is currently just under 5 percent, and that would be a reasonable expectation to have going forward. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.

Being Alan Greenspan

By Scott Lummer
Chief Investment Officer, mPower

Technical Terms Bond Federal Reserve Board NASDAQ

The question of the week is:

"I'm confused as to how the Fed's decrease in interest rates is affecting bond values. It seems like Treasuries have lost value since the Fed action in early January 2001. What can reasonably be expected for bonds the rest of 2001?"

Let's first look at what happened. On Jan. 3, the Federal Reserve Board cut interest rates from 6.5 percent to 6.0 percent. The move took the capital markets by surprise; in part because it didn't happen during a scheduled meeting, which is when the Fed would usually make such cuts. It could actually be considered to have been an emergency measure to bolster the economy. Most analysts perceive that there will be another cut during the regularly scheduled meeting later this month.

Over the past several months, equity market analysts have indicated growing concern about whether last year's rate increases may have slowed down the economy more than the Fed intended. Indeed, there are concerns about whether we might be headed for a recession. (If I seem overly critical, it's because I had a television appearance on Jan. 3 that was drastically scaled back because of the Fed news. I hate getting pre-empted.) The stock market responded very favorably to the news of the cut, although it could be said that the 14 percent jump in the NASDAQ was an overreaction.

Over the past few years, Fed Chairman Alan Greenspan has seemed to be able to wave a magic wand and set monetary policy to allow reasonable growth with low inflation. Is his magic wand finally running out of steam? The interest rate increases last year may have been too high and too fast. (Hey, here's a cool movie plot. A puppeteer finds a secret passageway into the mind of a Federal Reserve Chairman, buys many put options, and fiendishly starts wreaking havoc with the U.S. stock market.)

What About Bonds?

The reader seems confused about the effect the interest rate cuts had on bond values. This is understandable. If the Fed ordered a decrease in short-term interest rates, it seems logical that this would cause longer-term rates to drop as well, which in turn would cause bond values to rise (remember, there is an inverse relationship between market interest rates and bond values).

However, a cut in short-term rates could lead to inflation over the long term, which would cause bond values to fall. Still, in my opinion, this is not the reason why bond prices fell after the Fed cuts either.

Usually the bond market is impacted by either expectations of future inflation or other national or international monetary factors. However, lately the market has been driven by basic demand. The demand for one security compared to the demand for another is something that impacts all prices in the market. Many investors who didn't want to invest in the stock market in the second half of last year put their money in bonds instead. That is why the bond market did very well during 2000. When the Fed cut rates, however, many investors wanted to come back into the stock market. To purchase stocks, many of those investors sold bonds, which caused the prices to fall. So, it wasn't the rate cut by itself that hurt bonds. The rate cut increased stock values, which for a short time were competing with bonds for investors' attention.

The Bond Outlook

Related Reading Wall Street 101: Stocks, Bonds and Basics Shake Your Bond-bond A Simple Plan

What can be expected in 2001? In my opinion, while bonds can play an important role in a diversified portfolio, one should never invest in bonds with the expectation of large capital gains. There are years when interest rates will increase and cause prices to fall. And, there will be years like last year when the reverse occurred. However, I think it would be a mistake for an investor — particularly one with long-term goals — to invest in bonds hoping for short-term gains. The yield on short-term bonds is currently just under 5 percent, and that would be a reasonable expectation to have going forward. 

The information provided here is intended to help you understand the general issue and does not constitute any tax, investment or legal advice. Consult your financial, tax or legal advisor regarding your own unique situation and your company's benefits representative for rules specific to your plan.