The Hindu Business Line : Fed Reserve likely to be ready to change gear

In one of his speeches, Mr Greenspan said in jest that if what he had said had made sense, he had not made himself clear. The recent Banking Committee testimony is one such speech. In this testimony, the Chairman focussed on the possible reasons behind a flat US sovereign yield curve and the fact that the long end of curve had moved lower despite the Federal Reserve raising the Fed Fund rates. The Federal Reserve has raised rates six times in succession, by 25 basis points each time to take the Fed Funds rate to 2.50 per cent.

The debate on the yield curve has been going on for quite some time. Mr Greenspan spent a large part his last testimony on his take on why the yield curve had flattened. It is obvious that low yields on the long end of the curve made the Chairman uncomfortable.

The market reacted to the `puzzled' Chairman by selling the long end. In addition, inflation data after the testimony confounded the fear of the change in the pace of the Federal Reserve's move towards the `neutral rate'. The Core Producer Price Index grew at the fastest rate in six years. In this article, we will look at the possible reasons behind long-term interest levels.

One reason behind the muted yields may be that market participants have marked down their view of economic growth going forward. This may be on account of high crude oil prices and the perceived sensitivity of the US economy to energy cost.

However, stock prices have been rallying and credit spreads have narrowed during the same period. This does not go with this argument. Foreign central bank purchases of US Treasuries have often been cited as one of the reasons for long-term interest rates being low.

For most of 2004, the dollar has been in a declining trend and Asian central banks were aggressively intervening to prevent their currencies from appreciating. The data on Treasury holdings of Asian central banks and the change therein during last year is shown in the graph. The Korean central bank's report on reserves created a stir in the markets after the testimony. The report was purported to state that the central bank was looking to change the mix of their reserves and move into non-USD (dollar) currency exposure.

As the Korean central bank has around $200 billion of reserves, such a move would have resulted in a dollar sell-off. Though the central bank went into damage control, by stating that they would look at changing the mix only in incremental flows.

The largest US Treasury holdings are with Japan and China. They were also the largest buyers of US Treasuries in 2004.

The mortgages market in the US also remains robust and 30-year mortgage yields have dropped to levels only slightly higher than the record lows touched in 2003.

As the duration of the portfolios reduce, mortgage investors further bring the yield down by purchasing long-term securities to take care of the `negative convexity'. This has contributed to the recent downward pressure on longer-term yields.

Though long-term interest rates had declined in the US, yields and risk spreads have narrowed globally.

The German 10-Year Bund rate has declined from 4.25 per cent in June 2004 to 3.50 per cent in February 2005. The spreads on bonds issued by emerging market nations over US Treasuries have declined to very low levels. Over the past couple of years, many structured products have been carry trades, which receive the yield spread between long tenor and short end yields. As the outlook remained benign, these trades remained in vogue till recently. This may also be a reason for behind long term yields remaining low.

A large chunk of the world's savings are generated in Asia and Europe. These savings are invested in the US. The US remains the largest borrower of these funds, and is running a current account deficit of close to $600 billion.

China and India are emerging as the new global trading powers.

The integration of financial markets would mean that the world's pool of savings is being deployed in cross border financing of investments.

But, the sheer size of the savings and lack of large demand except from the US would mean that savings would continue to move to America.

The substantially accommodative policy is fast becoming a problem for the Federal Reserve, as history has shown that long periods of relative stability are prone to excess.

In a bid to prevent the Federal Reserve from being seen as being behind the curve, the Chairman has tried to steepen the yield curve and has cautioned the market about United States' huge current account deficit.

This may be the first time that a Chairman has commented and focused on a specific part of the yield curve.

After the recent interest rate moves, Mr Greenspan stated that this move made the yield curve less of a conundrum.

This signalled that the Federal Reserve would like to be ready to change gear, if required and would not like the market to react violently to panic selling at a later date.

(The author is Senior Manager, Corporate Treasury Sales - Western India for HSBC. The views expressed herein are his own and not necessarily those of his employer.)

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