Why Alan Greenspan Is Wrong About a Fed-Driven Bond Panic

Former Fed chairman Alan Greenspan. Source: Wikimedia Commons.

Stock market investors often pay little attention to other financial markets, particularly the bond market, which many perceive as being boring and unimportant. Yet recently, even those who usually ignore bonds have paid attention to big moves in bond prices, and former Federal Reserve chairman Alan Greenspan heightened the tension in the credit markets on Wednesday by forecasting what he called a another "taper tantrum" once the central bank starts to raise short-term interest rates. Despite his track record, however, Greenspan is probably wrong about the market's likely response to the Fed's next moves.

Panic 2.0?Greenspan's was referring to the big jump in bond yields in mid-2013 in response to the Fed's announcement that it was considering when to begin reducing its bond purchases under its quantitative easing policy. Within just a few months, 10-year Treasury yields soared by more than a full percentage point, going from about 1.6% to nearly 3%.

The recent move in the bond market has reminds some investors of what happened two years ago. February's low yield matched up almost exactly to the low levels in 2013, and rates have already climbed to 2.25%.

How the Fed is managing expectationsThe difference this time around, though, is that the Federal Reserve has given every indication that it is trying to keep any increase in rates as orderly as possible. On numerous occasions, the central bank has demonstrated its restraint in returning rates to more normal levels, citing various economic conditions as warranting a moderate approach toward tightening monetary policy. In 2014, 10-year Treasury yields fell by a full percentage point, defying expectations for rising rates even as the Fed eliminated its bond-purchase activity over the course of the year.

At this point, the only thing that should surprise investors is if the Fed takes a particularly hawkish course in raising rates. Even when the first rate hike happens, it's likely to be accompanied by accommodative language on other fronts, and most market followers believe we're highly unlikely to see the lockstep rate increases month after month that Greenspan's Fed tended to espouse. With rates only rising in fits and starts, the chances of a rapid upward rise in long-term rates -- while possible -- aren't as high as they otherwise would be.

For now, aggressive action from the Fed seems unnecessary. Inflation remains restrained, with this morning's report on producer prices showing further weakness. Gross domestic product growth in the first quarter was weaker than expected, and while some blamed winter weather, conditions in much of the country arguably should have encouraged more economic activity.

Overall, the Fed has consistently sought to minimize market reaction to its announcements, and it has learned from its past mistakes in that regard. Despite Greenspan's concerns, the central bank should be able to manage its monetary policy in a way to let rates rise gradually rather than in a panicked push higher.

The article Why Alan Greenspan Is Wrong About a Fed-Driven Bond Panic originally appeared on Fool.com.

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