The Hindu Business Line : Carry trade loses sheen

The Fed's interest-rate and policy-setting body, the Federal Open Markets Committee (FOMC), decided to up rates 25 basis points, ending their cutting spree, which began in January 2001 and finished with Fed Funds at one per cent for over a year - the lowest in 45 years.

Has it worked? Pretty well, one should think.

Although the stock market tanked from mid-2000 till the beginning of 2003, the economy never really slipped into a recession worth the name. GDP growth, on average, has managed to stay at 4 per cent levels - in fact, the last three quarters have seen 5 per cent. Consumer spending, fuelled by low interest rates and the housing boom, has led the economy.

The Fed Chairman Mr Alan Greenspan's hunch was right - rising productivity would keep inflation low while spare capacity in capital and labour would remove the pricing power of businesses, allowing interest rates to stay much lower and for longer than in previous easing cycles.

The FOMC has opted to stick to its stance of gradual tightening, unless incoming inflation data force a rethink. Almost, in vindication, June's non-farm payroll reported only 1,12,000 new jobs - much below the market's expectation.

Bond yields, which had been moving down even before the Fed meeting, promptly collapsed, with 10-year Treasuries pushing below 4.5 per cent and 2 years touching 2.5 per cent - about 30-40 basis points below their recent peaks.

Data have, in general, been strong, but for odd spots like durable goods orders. Even employment has grown at a healthy clip in the last four months taken together. The issue is whether all these will translate into rising inflation. On a year-to-year basis, core CPI (excluding food and energy) is still below 2 per cent but the last quarter's data is well above this. The Fed ascribes the recent jump to "transitory factors" and will not be panicked into changing policy. But June's CPI, due next week, will be crucial. The much-heralded shift to a "neutral" rate of interest may have begun, but it will be awhile yet before we reach that.

A big worry for the Fed is the effect of rising rates on property prices. Households are leveraged to the hilt and if house prices do fall significantly, both debt-servicing and collateral values will be at risk.

Another weighty reason for the Fed not to act in haste and repent at leisure.

At current yields, Treasuries do not seem to offer great value, especially given that we are at the start of the Fed's tightening cycle. The margins on carry trades - funding short and buying medium and long Treasuries - are not high enough to cushion a sudden spike in rates.

Bonds seem set to fall somewhat in the coming days.

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