Answering the Bond Market Conundrum

In February, Fed Chairman Alan Greenspan described the decline of long-term interest rates in conjunction with a rise in short-term rates as a “conundrum,” and suggested that long-term rates may soon rise. Greenspan was referring to the decline in yields on 10-year Treasury notes from 4.8 percent in June 2004 to 4 percent in early February while the Fed was raising the Fed Funds rate from 1.0 to 2.5 percent. Since Greenspan made his observation, the 10-year Treasury rate has risen to 4.19 percent as of May 2, only partially alleviating the need to answer the conundrum.

Several reasons have been proposed for the bond market's confounding actions. They include: a) the demand for U.S. Treasury bonds tied to the trade deficit, b) leveraged investor strategies, c) rational changes in the shape of the yield curve and d) the bond market's expectation for lower nominal growth. This article will address each of these rationales and provide our views. We also will state why we agree with Chairman Greenspan that long-term rates are likely to rise.

Trade Deficit. China and other countries with trade surpluses invest dollars primarily in U.S. Treasury securities. As a result, the trade deficit creates a continuous demand for U.S. Treasury bonds. This demand has an impact on the level of domestic interest rates. However, we note the decline in long-term government bond rates has not been unique to the U.S. Yields on 10-year Canadian, Euro, and Japanese government bonds have also fallen over the past several quarters. We do not believe that the U.S. trade deficit provides the answer to the conundrum.

Leveraged Investor Strategies. Borrow short/lend long has been a successful strategy throughout financial market history. Primary dealer borrowing accelerated in mid-2000 as the stock market bubble burst and dealers foresaw economic weakness and lower interest rates. Dealers borrowed at short-term rates and invested in long-term bonds to profit from the anticipated decline in rates.

A surprise has been that primary dealer net borrowing has expanded since mid-2004, when the Fed began to raise interest rates. Jim Bianco of Bianco Research postulates that the transparency of Fed policy has allowed dealers to continue their leveraged position. Dealers have continued to borrow short and lend long because they could quantify their risk. The result has been persistency in the yield curve flattening.

Dealers have not been the only speculators playing this game. Hedge fund managers have also identified the flattening of the yield curve trade. We believe the combination of leveraged strategies by dealers and hedge funds pushed long-term rates below a level warranted by the fundamental factors that traditionally affect these rates.

Shape of the Yield Curve. Ten-year Treasury yields are normally higher than yields on Fed Funds to compensate investors in longer-term maturities for the uncertainty related to factors driving bond yields and prices. The result is the traditional upwardly sloping yield curve. The yield curve shape is not constant over time and can be interpreted as an indication of bond investor's expectations for future rates.

The yield curve was abnormally steep in the summer of 2003 with 10-year Treasury rates at 4.5 percent and Fed Funds at 1.0 percent. The 3.5 percent spread between these rates indicated that bond investors believed that the Fed was too accommodative, suggesting that rates would rise. As the Fed started to raise rates in the summer of 2004, the bond market responded by beginning to move toward an average spread of near 1.75 percent. The spread between the Fed Funds rate and 10-year Treasury yields has narrowed from 3.5 percent in the summer of 2003 to near 2.0 percent currently. Although this narrowing occurred in a somewhat unconventional manner, the shape of the yield curve today is more normal than it was two years ago.

In a speech on March 8, 2005, Fed Governor Ben Bernanke indicated that the yield curve provides important clues for the Fed. He said “The funds rate will have reached an appropriate and sustainable level when, first, the outlook is consistent with the Committee's economic goals and, second, the slope of the term structure of interest rates is approximately normal, as best as can be determined.” He noted that the flattening of the yield curve suggests “the neutral funds rate may be somewhat lower today than in the past.” From this point forward, the flattening will likely occur in the typical fashion of short rates rising faster than long ones.

Nominal Economic Growth. In the long run, bond yields reflect nominal economic growth, which is the combination of real GDP growth and inflation. The yield on 10-year Treasury notes and the growth rate for nominal GDP tend to converge over time. Since 1964, the average yield on 10-year Treasury notes has been 7.4 percent and the average annual growth rate for nominal GDP has been 7.5 percent. Over the past 10 years, the average yield on 10-year Treasury notes has been 5.4 percent and annual growth rate for nominal GDP has been 5.2 percent. Currently, 10-year Treasury notes are yielding 4.19 percent whereas nominal GDP is 6.4 percent.

We believe that a convergence will result from a combination of higher long-term rates and a slowdown in economic growth. The recent pattern (i.e., trend in the monthly yields on 10-year Treasuries) suggests a further rise to the 5 percent range by the end of 2005. Moreover, the Fed, which arguably has the best record for forecasting economic growth and inflation, projects nominal growth in the 5 to 6 percent range. This range supports our view that the convergence will occur as a result of growth slowing and rates rising.

Answering the Conundrum. The two factors that had the greatest impact on the decline in long-term rates in the face of rising short-term yields are the shape of the yield curve at the beginning of this process and the impact of trend-following leveraged strategies that drove long-term rates below a level supported by fundamentals. The yield curve has now moved from an abnormally steep to a “normal” slope. The Fed's telegraphed measured pace of rate hikes provided dealers and hedge fund managers with an opportunity to profit from the flattening of the yield curve through the “carry trade,” borrowing at short rates and investing in long-term Treasuries. The most recent reversal in long-term rates may provide the first indication to trend-following investors that this trend may be ending. These traders know that exiting early is better than late. Both of these factors should be less important from this point forward.

From here, nominal GDP growth of 6.4 percent may be the most dominant influence on bond yields. The yield on 10-year Treasury notes of 4.19 percent should rise to close this gap over the next several quarters. The primary force driving these yields higher could be a continued rise in the Fed Funds rate. For now, most Fed officials are relatively sanguine about the level of economic growth and inflation. They continue to see some slack in the labor markets, so they are happy to see the economy growing fast enough to add about 200,000 jobs a month to gradually reduce the current 5.4 percent jobless rate without substantially increasing inflationary pressures.

Our Fixed-Income Strategy. We have maintained a below average duration for fixed income portfolios over the past year in anticipation of rising interest rates. This strategy has been right but not particularly rewarding. Yields on two-year notes have risen from 1.6 percent to 3.6 percent and yields on 10-year notes from 4.0 percent to 4.19 percent. However, the strategy has not been especially rewarding because the total return for two-year Treasury notes has under-performed that of 10-year Treasuries.

From this point forward, our strategy should prove correct and more rewarding. Yields are likely to continue to rise as the Fed methodically raises short-term rates. Since the yield curve has already flattened with the spread between two-year and 10-year Treasuries shrinking from 2.4 percent to .9 percent, the rise in short-term rates is likely to be reflected across the full yield curve. The additional duration risk of 10-year bonds relative to two-year notes means that the long-term bonds should under-perform during the remainder of the rising rate cycle. We will continue to emphasize short to intermediate-term maturity bonds in our portfolios.

Mark Toledo is president of Total Portfolio Management, LLC. Total Portfolio Management advises municipal pension funds on fixed income and equity investment strategy.

Advanced Investing Course Set for July

G FOA will roll out a new course, Advanced Public Investing, scheduled for July 18-19 in Chicago. Advanced Public Investing will provide participants a solid understanding of complex investment concepts that pertain to risk, reward, portfolio strategies, and structured security analysis.

The course assumes that participants have taken GFOA's intermediate-level Investing Public Funds course and are familiar with common investment instruments.

Instructors include:

• Ned Connolly, Vice President, Chandler Asset Management;
• Corinne Larson, Vice President, MBIA Asset Management Group;
• Henry Stern, Chief Investment Officer, City of Los Angeles; and
• Margaret Kerins, Managing Director for Liquid Products, RBS Greenwich Capital Markets, Inc.

Panel of Economists

Cause for Inflation Alarm?

Should public investors be concerned about the recent increase in the CPI? According to John Silvia, investors should be concerned indeed. Inflation has been trending upward for over one year. Factors that will help boost prices over the next year include: rising labor costs, declining productivity, and rising capacity utilization. Peter Kretzmer also agrees that investors should be concerned, and he foresees an upward drift in inflation over the next six months. The two factors that will have the greatest impact on inflation and interest rates over the next six months are energy and the state of the economy.

Carl Tannenbaum states that public investors should monitor upcoming trends in the CPI but not be overly concerned. Much of the increase has been due to energy prices, which are not expected to increase at the current rate. In addition, expectations for future inflation remain calm. The key to interest rate trends over the coming months will be the pace of Fed tightening and federal budget discussions.

According to Lacy Hunt, the trend in inflation appears (on the surface) to be moving higher. However, the increase in inflation over the past 12 months will likely be temporary. Hunt highlights several fundamental factors that suggest too many goods chasing too little money—and thus lower inflation over the long term. In the past three months, the growth rate in the M2 money supply stock has slumped to only 2.1 percent. Last year, the M2 money supply grew by only 4.5 percent, which is below the long-term trend of 6.7 percent. In addition, real wages continue to decline due to slack labor markets. Real average weekly earnings were 0.5 percent below the level a year earlier.

CPI Jumps to 4.5 Percent

The consumer price index (CPI) rose at 4.5 percent in February. Although much of the increase is due to a spike in energy prices, some are concerned about the 3.1 percent annualized increase in the core CPI, which excludes food and energy. The Fed's latest “Beige Book”—while reporting business expansion in all Fed Districts from late February through early April —cautions that “Price pressures have intensified in a number of districts, and most report that high or rising energy prices are a concern across sectors.”

A recent National Association for Business Economics survey asked what were the reasons for the recent surge in oil prices. Economists mentioned the following as the top three reasons: additional demand from India and China, the weak dollar, and speculative activities. The NABE survey predicts that GDP growth will be 3 to 4 percent in the first half of 2005.

The databank's average money market fund maturity statistic is at 37 days—an unusually short maturity that suggests that short-term interest rates are rising (average maturity over the past 10 years has been 50 days).

RGM

Fed Rate Hike #8

The Fed Open Market Committee continued its series of rate increases by raising the Fed Funds rate by 25 basis points in March. At its meeting on May 3, Fed watchers expect the central bank to raise the rate another 25 basis points to 3.00 percent, which would be the eighth consecutive rate increase since the Fed began raising rates in June 2004. The Fed funds futures market predicts that the Fed will raise the Fed Funds rate to 3.75 percent by the end of the year.

RGM

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