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Maybe the Fed has already Eased Monetary Conditions

Author: Bob Lang (info)
Website: http://trade-mentor.com
Posted: May 23rd, 2007 at 8:18 am EST
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We’ve been witness to an odd situation for many months…an inverted yield curve. Odd…because it’s not often that interest rates can be static for so long. Further, the bond market and the Fed typical think in synch. For months the two sides have been shown different legions…the Fed being an inflation fighter has been working to keep price increases at bay…while the bond market, deftly afraid of inflation…is more concerned about an economic slowdown. In fact, bond traders are worried that without a rate hike a recession is inevitable. This fear is very realistic. However, I may have found evidence that the Fed is in their court…and very well may have started the easing process.

How do we correlate rates with the stock market? Remember, when bonds rise rates are dropping and offer a lower cost to borrow. This in turn shows confidence in business to borrow and expand operations. Further it allows bond investors to capture some price appreciation as the demand for treasury securities rises. It’s all good…plus, consumer borrowing steps up with a lower cost structure. Bottom line, lower rates are good for the stock market as it also portrays low inflation.

An indicator for short term borrowing I follow is the IRX, or short term interest rate. It’s a composite of shorter term paper similar to the fed funds rate. While sitting over 5% in late February, the yield has come down dramatically to become nearly aligned with the 10 year rate. In fact, it’s below the long bond yield for the first time in many months! Is this the Fed’s work? Most likely it is, yes. We’ll have to be attentive to the upcoming data, but it wouldn’t surprise me if the Fed has suddenly shifted gears to focus on the slumping economy. A second quarter growth estimate appears to be 2% or less, which will be the second straight quarter of below trend growth. If that should continue the economy is most assuredly going to fall into a slump, if not full blown recession. Worried about inflation? Yes, that’s been the message from Bernanke and Co. But let’s hope the Fed is looking at this situation closely and is not too late in their response.

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