Taxable Fixed Income Strategy

The first quarter of 2007 can be described as a transitional period for the taxable bond markets. Prior to February, market discussions centered on two questions:

1. To what extent will short term interest rates need to rise in order to meet the Fed’s inflation requirements?
   
   
2. Is there enough yield curve inversion to stem economic growth?

The market’s response to this dilemma is shown by comparing present Treasury yield levels to the January peak.

As shown, at the end of January, two-year Treasury yields approached 5% while inflation reports showed only sporadic signs of moderating. Furthermore, in comparing the 2-year Treasury to the 10-year Treasury, the yield curve inversion was at negative 9 basis points. A yield curve inversion is historically a precursor to an economic slowing or recession, and the 9 basis point margin seemed too narrow to be predictive of a slowing economy or a recession. Only two months later, there was a precipitous drop in yields and the curve inversion disappeared. So it leads to the current question - Why the dramatic change in market sentiment during the subsequent two months, as investors appear less concerned over the resilience of the economy and stubborn inflation?

First, we know there is a time lag between an adjustment in monetary policy and its effect on the economy and ultimately, inflation. To date, the Fed has raised its benchmark short-term Federal Funds target 17 times over a period of almost 3 years. Past data shows a 9 to 12-month time lag between a Federal Open Market Committee policy decision and its flow through the system. Most experts could successfully argue that at least 12 of the 17 rate hikes were needed to reverse an overly stimulative monetary policy. Therefore, the balance of the rate increases can be defined as “restrictive.” There is now growing evidence that Gross Domestic Product (GDP) growth is beginning to slow under the weight of this restrictive policy.

Second, changes in 3-month Treasury bill yields reflect both current Fed policy and future expectations. It is interesting to observe that short-term T-bills reached a high yield point shortly after a peak in the Commodity Research Bureau (CRB) price index and a change in the Fed’s periodic policy statement. Unfortunately, because energy price volatility influences the CRB index, a decisive change in the direction of inflation remains unclear.

Third, while housing is rarely the sole cause of recessions, median home prices are beginning to moderate or fall and the inventory of unsold homes is mounting. This, combined with the rise in mortgage defaults, raises concerns that the Fed has been too restrictive and must lower interest rates soon. This may be the strongest factor explaining the notable drop in short and intermediate maturity yield levels and resistance to the Fed’s negative comments on inflation.

Finally, costs associated with labor may not be the feared inflationary grim reaper. In spite of the historically low 4.4% unemployment rate and select labor shortages, wage/benefit increases have been muted by increases in corporate productivity.

As stated earlier, interest rates are now somewhat lower than year end levels. This has benefited Oakwood clients as they enjoy good cash flow from coupon payments and modest growth in asset values. We believe the bond market is only in the early stages of a rally. However, the key to its success hinges on INFLATION, INFLATION, and INFLATION. While inflationary pressures may have already peaked, for any sustained change in interest rates to occur, we believe the impact of the restrictive monetary policy must continue to flow through the economy. Otherwise, investor sentiment will shift back and forth between bullish to bearish on any given day or data point.

As part of our second quarter investment plans, we will look past market gyrations driven by emotion and continue to extend short maturity positions during market pullbacks. Furthermore, we proceed to swap fully priced Federal Agencies and more risky corporate holdings into more price-responsive higher quality Treasuries. Finally, we will monitor the progress of inflation as a guide to overall duration management. This entails a potential shift in client portfolios from neutral to more aggressive versus respective performance benchmarks. Meanwhile, our primary goal is to add to first quarter returns in a controlled fashion.