After a rally that had knocked some 25 basis points off the long bond yield since early this month, today’s half-point pullback suggests that Treasuries have been restored to a range reflecting short-term balance in the market’s upside-potential vs. downside-risk assessment. At a yield between 5.70% and 5.75%, the 30-year Treasury is back to levels that held in late summer prior to September’s oil price surge, which imposed an additional risk premium on government debt (“Greenspan’s Dilemma,” September 19, 2000). Strong signals from the FOMC and various Fed officials that the oil price increases would not be accommodated by monetary policy appear to have reassured the markets and contributed importantly to the bounce-back. From here, opportunities for additional near- to mid-term gains are likely to hinge on chances of the Fed moving into easing mode by early next year. While such an event is now fully priced into interest-rate futures contracts maturing next March, the nation’s long-term creditors probably will want to see convincing evidence of an oil price retreat before affirming those expectations. 

Still, if immediate upside prospects remain clouded by the oil-price spike, there is little question that current nominal Treasury yields offer attractive real returns in a deflation-biased environment, limiting downside risk. With the dollar price of gold showing no inclination to move out of ranges around $270 per ounce, and the dollar’s foreign exchange value rising to levels last seen in the mid-1980s, claims to fixed-dollar repayment streams at these yields are a bargain. Providing that at some point oil prices revert to long-term equilibrium levels around $20 per barrel, and the Fed brings short-term rates back in line with real-return fundamentals, sustainable long-term yields below 5% could well be a reality within the next year.

At the margin, bonds also figure to get support from what could be an important shift at the central bank. Although it received virtually no media attention, Fed Chairman Alan Greenspan’s speech last week to the Cato Institute monetary conference included a passage questioning the Fed’s mechanistic, growth-limiting approach in a period of intense, productivity-boosting technological innovation. The models policymakers develop to explain the way economies work “are a major simplification of the many forces that govern the functioning of our system at any point in time,” Greenspan said. “Obviously, to the extent that these constructs…fail to capture critical factors driving economic expansion or contraction, conclusions drawn from their application will be off the mark.” In the midst of the surge in innovation experienced over the past five years, “many of the economic relationships embodied in the past models no longer project outcomes that mirror the newer realities.” The Fed chief then asserted: “When confronted with a period of structural change, our policy actions much be based on identifying emerging trends from surprises and anomalies in the data and then carefully drawing their implications. It would be folly to cling to an antiquated model in the face of contradictory information.”                   

In itself, Greenspan’s language here does not necessarily preclude the possibility that the Fed’s earlier estimate of 2-2.5% real growth “potential” has simply been replaced by a higher arbitrary limit, say in the range of 3.5-4%. There are also hints, however, that Greenspan is inching his way back toward a price-rule policy orientation. In the Cato speech, for example, he pointed to Treasury’s indexed bonds as an indication that the impact of the oil shock on inflation expectations “has been virtually nil.” If Greenspan is, in fact, moving to jettison the Phillips Curve/output-gap paradigm, the positive implications for bonds – indeed for all dollar-denominated portfolio assets – are potentially enormous.