Friday, July 01, 2005

Fed hikes another 25 bps - Not the time to invest in bond funds

As expected, the Fed Open Market Committee (FOMC )raised the Fed fund rate by 25 basis points. More crucially, it signalled continued tightening down the road, and not a relaxation, as some investors were expecting. The result was a loss of over a 100 points for the DOW after the FOMC announcement came out at 2:30 pm.

The Fed indicated that while long-term inflation remains under control, near-term inflation concerns remain elevated. This increase in Fed funds rate might slow housing , which has been an area of concern, if 10 yr and 30 yr yields rise. (See Greenspan's comments: http://gaurav1.blogspot.com/2005/06/alan-greenspans-comments-on-housing.html) 10 yr yield actually fell by 2 bps today after FOMC announcement, indicating further tighetening of yield curve. The current economic expansion has been largely driven by consumer and not by business. Consumer wealth has largely been driven by higher home values, and home equity lines against these values. Any significant decline in home values might thus have a extremely negative impact on overall economic growth. The best hope here, I guess, is to have a soft landing in home prices.

I had discussed a couple of days back whether this is the time to invest in high yield bond funds.
(See http://gaurav1.blogspot.com/2005/06/time-to-move-to-high-yield-bond-funds.html). I think it is better to wait and watch. If Fed keeps increasing the short term-rates, long term-rates might follow suit (so far they haven't).

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