Why This Interest Rate Cycle Is Different
On Tuesday, immediately after Chairman Greenspan
signaled that he is still vigilant against deflation, Treasury prices spiked
higher and the July Fed Funds Future began to price in a 100% probability of a
25
basis point cut at the FOMC’s next meeting. At the same time, the S&P
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to move higher.
This type of behavior in the interest rate markets confuses many
investors, as lower rates typically signal more economic weakness is on the
horizon. Well, as I discussed in my column
last week, it is very common for
interest rates to move lower during the final phases of a recessionary periods,
as evidenced by the fact that the prices of the two financial instrument have
moved higher during the final three months of the last eight recessions.
However, this time around, the positive correlation may last longer than three
months this time around and the moves in interest rates make be more
pronounced–creating even more confusion among investors.
A Different Fed This Time
In an unprecedented move, the FOMC declared at
its meeting in May that it would begin targeting prices and economic growth
separately, given the small possibility of deflation. Typically, interest rates
tick up on the first signs of an improvement in the economy, as Fed officials
begin to verbally prepare the markets, long in advance, that a tighter monetary
policy should be expected. This time around, however, falling prices give the
Fed the flexibility to keep interest rates low until the economy is on solid
footing–possibly waiting until a 4% to 5 % growth rate is confirmed, which
could take a few quarters.
This precaution is especially important because a
premature increase in rates could cut off the source of cheap financing that is
now available to consumers (via low mortgages) and businesses (via low cost of
capital). If this source of liquidity were to dry up, the economy would
undoubtedly go right back into a recession.