Taxable Fixed Income Strategy
On June 28, the Federal Reserve (Fed) kept its key Federal Funds rate at 5.25%, for the eighth straight meeting. They stated that core inflation (absent food and energy) is showing signs of improvement. Supporting this claim is the Fed’s preferred Personal Consumption Expenditures (PCE) Index. Excluding food and energy, the PCE Index rose 2.1% during the past year, down from 2.4% and is now closing in on their 1% to 2% desired target range.
It continues to be our view that persistence on the part of the Fed is setting the stage for a favorable bond market. This seems to be the most plausible forecast, even if the economy rebounds modestly from the very weak 0.7% annualized GDP economic reading in the first quarter. However, it is also important to observe the behavior of long Treasury prices over a four year time frame. The following graph shows a period of time when monetary policy was both restrictive and easy. This provides us with insight as to the effectiveness of monetary policy and can be used to time structural changes in portfolios, as part of Oakwood’s management.
During periods when Treasury prices reached unsustainable levels, investors were wise to take gains and shorten bond positions. Conversely, during periods when prices fell to low levels, there were opportunities to lengthen portfolio structures. These technical market gyrations are indicative of shifts in market psychology, being triggered by fears of either too much economic growth and rising inflation, or anticipations of a slowdown and a calming in inflation expectations. We feel these are normal market reactions to unpredictable day to day economic data. Unfortunately, even though the price volatility may be somewhat technical in nature, for investors who have exercised poor market timing or structured portfolios too aggressively, losses can be significant. To avoid this, Oakwood uses these types of studies to increase the probability of success.
In fact, during this difficult interest rate period, Oakwood preserved capital and even generated modest positive returns. This is a testament to our controlled investment process and resistance to high-risk derivative type investments or newly developed products designed to promote above market yields. Instead, changes in our portfolios involved the systematic reduction of corporate bond exposure, in favor of higher quality, more price sensitive government bond positions. This decision is based on our belief that earnings momentum within corporations will slow, causing risk premiums (the yield advantage over Treasuries) to widen further, making investments in corporate bonds less attractive.
Another concern involves companies like Amgen Inc. that, through the bond markets, are taking advantage of cheap sources of money to raise large amounts of capital. In fact, new issue volume in May exceeded $128 billion, making it the third largest ever. The pattern of widening corporate bond spreads should continue until the Fed shifts its policy in favor of economic growth. Absent a marked slowdown in current economic fundamentals or an unexpected financial shock, we do not expect the Fed to lower interest rates until early in 2008.
Nonetheless, we still expect bond yields to fall modestly. This means that we will continue to shift short bond holdings to the 3 to 5 year maturity areas. This action will move portfolio durations neutral to their respective benchmarks and we intend to further lengthen portfolio durations soon. For now, there continues to be a delicate balance between the negative effects of defaulting sub-prime mortgage loans on the consumer and the economy overall versus the Fed’s mandate to squelch inflation. In fact, in their latest statement, the Fed has stated that “lower inflation needs to be convincingly demonstrated.” We believe that they will be successful and we see current yield levels as attractive.
