The Hindu Business Line : Post-Fed meeting: Bond rally likely

IF a Martian landed on earth today, he can be forgiven for thinking the Federal Open Markets Committee is the only game in town. Such is the aura surrounding the meetings of the interest rate setting body of the US, Federal Reserve.

Bond yields the world over (including our own) are driven pretty much by what the Fed does or says, especially in the immediate aftermath of the FOMC meetings and fortunes can be made or lost betting on Fed actions.

What makes the current meeting especially suspenseful is the perceptible slowdown of the US economy in Q2 and Q3. The second quarter GDP growth was just 2.8 per cent and consumer spending was tepid. The ISM's and Fed's manufacturing indices fell, although they are still in positive territory. Industry still has considerable unused capacity.

The FOMC increased interest rates 25 bps at each of its last two meetings and another now, of the same magnitude, is a near certainty. The debate is more about what it will do as we finish 2004 and in 2005. Will it ignore negative data and stay the course in raising rates to the "neutral" level, which is neither stimulative nor restrictive? Making things devilishly complicated is the Fed Chairman, Mr Alan Greenspan's admission that he himself does not know what the neutral level is - - "We will know only when we get there," he says.

The US central bank chief thinks the present soft patch is transitory and has occurred mainly because of high oil prices. He warns, however, that the energy demand- supply balance is fragile.

Significantly, issues viewed as "critical" by many economists - the low savings rate and rising fiscal and trade deficits - do not seem to play much of a role in the Fed's approach to and formulation of monetary policy. On the few occasions that he has addressed them, Mr Greenspan has asserted that he does not see any risk of financial market disruptions arising from these problems.

The centre of attention in recent times has been the post-meeting Fed statement. Mr Greenspan and his colleagues are unlikely to deviate from their stance of a "measured" pace of rate increases. They are likely to reiterate the view that inflation risk is dormant and refer to the current (brief?) phase of muted growth. Directly or indirectly, the statement could signal slowing rate increases, if conditions warrant.

The bond market has already discounted the weak data in good measure. Ten-year yields are brushing 4 per cent - down from recent highs of 4.9 per cent. But yields on two-year notes haven't fallen much, possibly because of the Fed's current up move and those expected, resulting in a flatter yield curve.

Yet bonds are likely to see a post-meeting rally, given low inflation and the risk of growth running out of steam.

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