Taxable Fixed Income Strategy
“Ultimately, the economy is going to rebound strongly and the Federal Reserve will be forced to raise interest rates.” This statement and similar statements are being uttered by economists and market commentators alike, with the feeling that the fundamentals leading to a strong, sustained period of economic growth are in place. To support this position, the pundits point to the experiences of past economic cycles, when aggressive monetary policy and tax cuts created new jobs and propelled the economy forward. They also suggest that as recent government surpluses turn into deficits, interest rates must move higher. Historically, an early barometer forecast for this scenario was a strong rally in stock prices, followed by concerns that inflation would return, then a call by the Fed to raise interest rates, mirroring today’s environment.
The data backing up this scenario for a strong, sustained period of growth is muddled, and may not mark an end to the declining interest rate cycle that began over 20 years ago. As an example, recent economic statistics reflect strong housing and near record levels of mortgage refinancing to support a continuation of strong retail spending. However, this was offset by an unexpected decline in durable goods orders which include big-ticket items designed to last more than three years, such as cars and refrigerators. Clearly, the economy is beginning to grow as evidenced by the second quarter GDP growth at an annual 3.3% rate, but keep in mind, this is hardly enough to create badly needed jobs. Furthermore, while some may argue the pending deficits create some investor apathy, history shows many periods when interest rates fell as deficits grew.
As shown in the following chart, each time economic data shows conflicting signs of growth, investor sentiment is pulled in various directions. This increases market uncertainty and accelerates large daily swings in bond prices.
We find these daily price changes to be useful when deploying new money, restructuring existing portfolios at attractive price levels, and capturing gains during periods of unusual market strength. This strategy will continue until a clearer picture of economic direction surfaces.
Overall, we remain cautiously optimistic about the bond market, but continue to be sensitive to factors, which could change our view. To draw on the opening statement of this Taxable strategy, we agree that strong growth can easily alter inflation expectations and force the Federal Reserve to ultimately raise short-term interest rate targets, which typically results in a drop in bond prices and an accompanying spike in yield. However, after several recent months of bond market weakness due to strong growth expectations, the yield on the 10-year US Treasury has actually declined 65 basis points from a high of 4.60%, corresponding to an increase in market price. In addition, despite the ongoing anxiety caused by the reaction to daily economic releases, 3-year US Treasury yields remain near 2.0%, only 10 basis points higher than December 31, 2002 levels. As a result, bond performance for all Oakwood product categories is positive year-to-date and exceeds the reported level of inflation.
We remain mindful that interest rates are historically low and market conditions can change quickly. As pointed out in past editions of the Oakwood Outlook, we believe that declining energy prices are necessary to sustain economic growth. Presently, prices appear to have stabilized and are trending lower. A continuation of this trend could prompt us to shorten the duration of client portfolios as a measure to protect market gains. This would also prompt us to over-weight corporate positions as companies benefit from a strong economy and good earnings.
Another variable worth monitoring is the steady increase in gold prices, as shown in the following chart.
Rising gold prices are synonymous with an increase in the demand for this commodity, while prices for other industrial based metals are also rising. If the demand is accompanied by a substantial improvement in economic activity, inflation concerns would emerge and interest rates would likely move higher. Therefore, at this time, a conservative approach to investing is appropriate. We will continue to manage each portfolio’s duration within a somewhat narrow band versus its respective benchmark, and as stated earlier, will use daily price changes in an attempt to enhance returns. It remains our goal to make 2003 the fourth consecutive year of positive bond returns.
