Question:
Is there anywhere one can go to get a basic primer in reading and interpreting the bond commentary on the News Now page?

Answer:
Knowing what interest rates are going to do is a knack most investors would like to have. Unfortunately, there are so many variables at play that the twists and turns of the market have surprised the most brilliant mathematicians and economic analysts in the field. Fortunately, there are a few beacons in the fog. I hope the following will provide some light and only a little fog.

The Federal Reserve is charged with the responsibility to see that the U.S. economy maintains a relatively stable course. When the economy speeds up (high production, high consumption, high employment), chances are, based on the way things have worked in the past, inflation will crop up and dilute the value of money. In order to prevent this, the Fed has the ability to raise a couple of key interest rates. By raising the cost of borrowing money, business slows down and inflation is avoided.

The rates the Fed has power over are the federal funds rate and the discount rate. The fed funds rate is the rate banks charge each other for overnight borrowing. The Fed targets a particular level of the fed funds rate and then uses one of its tools (called open market operations) to bring it about. This tool is the ability to change the amount of cash in the monetary system, thereby increasing or decreasing its value.

The discount rate is the rate the Federal Reserve would charge a bank to borrow from the Fed (something banks don't want to do since it indicates to the Fed that the bank does not know how to manage its cash flows). The Fed meets about every six weeks to review its monetary policy and make changes if necessary. The group of Fed officials in this context is called the Federal Open Market Committee (FOMC).

The current argument against rate increases is that the economy is fundamentally changing with technological advances driving up productivity so that businesses do not have to charge more for their products and services. Another is that the old economy was controlled by the high costs involved with waging the "cold war." With that burden substantially reduced, the government has less need to compete with the civilian business sector for money so the long term outlook is, therefore, deflationary rather than inflationary.

But these are theories that the Fed cannot just suddenly embrace. The economy in 1999 was booming by just about any measurement and the Fed raised interest rates six times between June of 1999 and May of 2000. Some say the Fed raised rates too high which brought about the economic downtrend that we currently find ourselves in.

When the fed funds rate is changed, the banks will also change the rate they charge their customers to borrow. The prime rate is the rate banks charge their best business customers for loans. Interest rates, therefore, permeate the financial system as lenders seek to obtain borrowers.

The primary way of controlling the value of money, as mentioned above, is through injecting funds into or draining them from the monetary system. The Fed does this by purchasing or selling Treasury securities. The Federal Reserve is not the organization that offers the securities on behalf of the government, that is the Treasury Department's job. The Fed just uses this operation as a tool to control the money supply. When they purchase Treasuries, obviously, the money, which was not in any regular bank previously, is now added to the amount flowing through the banking system. And, contrary to what seems like common sense, money is not a fixed quantity but can grow or shrink depending on how it is used. When banks have more reserves, they can lend more money which in turn is deposited somewhere else in the banking system, enabling more money to be lent out, and so on.

When the Fed sells Treasuries, the money goes out of the system and back to the Fed. Another way the Fed controls the money supply is by changing the reserve requirements of banks.

The way mortgages fit into all of this is that they represent money that is lent out to be paid back with interest. This debt can then be sold in the financial markets in the form of mortgage backed securities. An investor evaluates the levels of risk and reward to decide what the most profitable investment is. Treasuries are virtually risk free because they are issued by the government and the government prints the money -- if the government doesn't have enough money to pay off its debts, it can always make some more - though the preferred method of paying off old debt has been by using the proceeds of new debt offerings.

Mortgages are more risky because borrowers can pay off their debt sooner than expected (depriving investors of interest income), or borrowers can stop making payments altogether and default on their obligation. Obviously, investors will demand a higher return on a mortgage-backed security than on a Treasury security.

So the mortgage securities have to follow the government bond market to some extent. The price of the security will also be determined by the interest rates of the mortgages underlying the security.

The major secondary market agencies, Fannie Mae, Freddie Mac, and Ginnie Mae, establish prices for pools into which mortgage loans or groups of loans can be committed. These prices are a major determinant for lenders when they set their daily rates. But not all loans are sold to these agencies. Some lenders keep loans in their own portfolio or sell them to other lending organizations. These loans may or may not be securitized and the needs and abilities of the lending institution determine product pricing.

But getting back to the bond market at large, since the price of a bond is determined by a bid and offer process, a number of factors are involved in evaluating the instrument. One factor is the coupon rate, that is, the fixed amount of interest that is paid on a regular basis to the owner of the security. But many investors are more concerned with the yield that the security offers. If one must pay more than the face value of the bond, the net effect is to reduce the original yield from what it would have been at par (paying only the face value). On the other hand, paying less than the face value will increase the yield since at the end of the maturity period, the whole face value will be received in addition to the interest payments previously received.

If interest rates go up, Treasury coupon rates will also go up (remember, the government is borrowing from the investor). Current security issues will therefore decline in value. Who would pay full price for a bond that won't make interest payments as high as another bond with similar risk characteristics? So the threat of higher interest rates has a negative effect on the bond market.

But another thing that will dilute the value of bonds is inflation. If you lend high-value money and get paid back with low-value money, you won't make what you had hoped to make in terms of buying power. So the Fed's campaign to avoid inflation is in one way a good thing, especially for longer maturing securities since they are at risk for a longer period of time. This risk is why investors usually demand a higher yield on longer termed bonds.

But, as you may note from looking at a yield history for the year 2000, shorter-termed Treasuries can have a higher yield than longer ones. This is known as an inverted yield curve and last year's was an aberration, caused by an unusual situation.

The government has actually been taking in more money than it has been spending (yes, hard to believe). As a result, it does not need to borrow as much money so it is issuing fewer Treasury securities is buying back securities it had issued in the past. Since everyone knows that reduced supply means high demand and, therefore, value, the long bond (30-Year Treasury Bond) rose dramatically in relation to shorter securities. This is because traders believe that the government will save more money if they reduce longer-term debt (fewer interest payments to make). Of course, as explained above, the higher price reduced the yield.

As the economy began to show signs of slowing down, the shorter end of the bond market began to look more attractive since the next round of Fed actions would be rate cuts to stimulate business and consumer activity. In September the yield on the 10-Year Treasury Note finally fell below the 30-Year Bond.

The mortgage market uses the 10-Year Note as a benchmark (most mortgages are for 30-years but most don't last more than about ten). When the 10-Year Treasury Note yield falls, mortgage backed securities' yields can also be lowered yet still be competitive. This means that the mortgages underlying the securities will also have lower interest rates.

The economic releases are one of the means by which the market second-guesses what the Fed will do. As far as the bond market goes, bad economic news is normally good news since it reduces the likelihood of inflation pressures building up and, therefore, reduces the need for the Fed to raise rates. If the news an economy headed for recession (usually defined as negative economic growth as measured by the gross domestic product for two quarters or more), the Fed will cut rates to lower borrowing costs.

But this rule of thumb is complicated by the market expectations of what will be revealed in the releases. If the market thinks that a release is going to show a big change, and the change is not as big as expected, the market's reaction may be just the opposite of what the numbers seem to show.

Another complication is the fact that market participants will focus on different influences at different times. A hard piece of economic data may be overlooked because something else is occupying center stage -- perhaps a comment by Federal Reserve Board Chairman Alan Greenspan.

And the financial world is interconnected, with different markets exerting their own influences. Institutional investors usually are the market movers. They hedge positions by buying or selling in other markets (stocks, commodities, currencies, etc.). Even here, the standard formulas break down as times change. The Dow is now considered as representing the old, manufacturing economy. The Nasdaq, which has many high-tech companies represented in its composite number, is seen as representing the new, information-age economy. This is why the course of the two indices may act independently of each other and why both are getting attention as opposed to the traditional concentration on the Dow.

Another change has to do with the globalization of financial markets. The network of relationships among the markets of the world is becoming tighter. And the financial world is also related to the political world. If political events generate financial uncertainty, it will cause investors to move from areas of high risk to areas of low risk, i.e., usually to the U.S. Treasuries market.

These are just a few of the basics of the market. I advise you to check out the financial section of a good bookstore. There are numerous books on the markets, on economic indicators, and on the Fed. Also keep an eye on the News Now page as more information resources will be added.

Sorry I can't tell you what the market is going to do tomorrow but I hope I have answered some questions concerning the bond market and I hope that my explanations don't contain too many errors.

Dave Meury
News and Information Editor