Taxable Bond Commentary
Clash of the Titans: Monetary Policy versus Fiscal Policy

Monetary Policy Impact

The Federal Reserve, through its use of monetary policy, strives to maximize economic growth while maintaining price stability. To achieve this goal, the Fed has the authority to increase or decrease the amount of liquidity available for lending in the banking system. This helps set consumer and business lending rates. In an effort to stimulate our ailing economy, the Fed has pulled out all stops to enhance banking system and capital market liquidity by injecting huge amounts of cash.

The Federal Reserve also recognizes the vital role housing plays throughout the economy. Through large and ongoing intervention (buying) of Treasury securities, it seeks to shrink supply of Treasuries and stabilize mortgage rates. This process is normally effective as Treasury yields fall and mortgage rates typically follow. However, mortgage rates are now struggling to remain low under the weight of a seemingly endless supply of new Treasury securities. The following chart shows the correlation between a fixed home mortgage rate and 10-year Treasury yields.

Recently, as Treasury yields moved up, mortgage rates followed. If the Fed does not find a way to halt this situation, it may be harder to dig out of recession. What is causing this decoupling to happen?

Fiscal Policy Impact

Bond investors are increasingly fearful that multiple Government stimulus programs will produce out-of-control budget deficits. Funding these programs will require enormous borrowing in the Treasury markets for the foreseeable future. Over time, this could prompt a precipitous drop in the dollar and propel inflation higher. This would be the kiss of death to the Fed’s other role, which is to seek price stability. Adding to this problem are Government retirement promises and sponsored health care programs (Medicare and Medicaid).

We believe this dilemma has put the Federal Reserve’s role at odds with the Government’s need to stimulate. To resolve this, we urge Congress and the Administration to put forth a plan to deal with the potential ramifications caused by unprecedented borrowing to pay for economic stimulus. If they do not, the Fed may be unable to stop the recent rise in Treasury and mortgage rates as it is forced to restrict monetary policy.

We will handle this situation by adopting a barbell strategy in client portfolios. This entails the sale of 4-to-6 year holdings, in favor of shorter 1-to-2 year alternatives. To achieve our target duration of 3.5 years for intermediate maturity clients, we invest a portion of the remaining proceeds in high coupon 10-year Treasuries. This completes the long end of the barbell structure, and positions our clients to earn attractive returns from the flattening yield curve.

In addition, we begin to shorten select 5 to 10 year corporate bond positions. This provides protection against unforeseen earnings shocks which would result in yield spreads widening. However, we plan to continue to maintain an overweighting in corporate bonds.

We intend to remain highly conservative until such time as the Federal Reserve and Administration dispel inflation concerns. We are confident that the Fed, if needed, will act aggressively by raising short-term rates and draining excess reserves from the banking system. We look forward to the time when we can again extend portfolio durations. Until then, we emphasize above market income, security selection and yield curve positioning to aid us in preserving capital.