November 4, 2005

Volume 23, Number 11

Portfolio Management Firms Provide Investment Tips

Fed Chairman Greenspan to Retire; Bernanke Vows to Continue Course

Fed Holds Conference on Payment Innovations

GFOA Web Site Provides Forum to Facilitate Hurricane Assistance

Performance Benchmarks

Panel of Economists

Databank

Interest Rate Outlook

Portfolio Management Firms Provide Investment Tips

I n a recent online interview, Public Investor asked portfolio managers from three firms to share their tips for local governments investing short-term funds in the current interest rate environment. Participating in the interview were Chris Nauseda from JPMorgan Asset Management, Byron Gehlhardt from MBIA Asset Management, and John Hoeting from Fifth Third Bank.

Public Investor: Where do you see value on the short end of the yield curve (maturities less than one year)?

JPMorgan Asset Management: Investors are focused on being as short as possible. The short end of the yield curve is steep—much steeper than it was six months ago. If you look at commercial paper (rated A-1/P-1) over the past five years, overnights have averaged approximately 2.37 percent while the 180-day yields have averaged 2.48 percent—so that’s a pick up of 11 basis points (1 basis point is equal to 0.01 percent). Right now, 180-day commercial paper is yielding approximately 47 basis points more than overnights, so you can see how steep it is at the very short end (source: Bloomberg).¹

Exhibit 1: Movement of the Yield Curve (During the Past Eight Weeks)

Fifth Third Bank: The current and historical yield curve relationship between overnight money and one-year maturities is extremely dependent on expectations of the economy and future inflation as well as the monetary policy of the Federal Open Market Committee (FOMC). Ultimately, in order to determine value, investors must make a judgment decision between their own expectations versus the monetary policy anticipated by economists and the financial markets. The FOMC continues to remove the accommodative monetary policy at a measured pace, increasing the Fed Funds target rate by 25 basis points in each of the last 11 meetings from mid-2004 to present. As a result, in the ultra-short spectrum, investments must be evaluated by employing a breakeven analysis with certain interest rate assumptions. Investments further out on the short yield curve are viewed similarly, with emphasis placed on these anticipated interest rates across several FOMC meetings.

Looking at the current and historical spread between overnight money and six-month securities, this relationship has narrowed considerably as many market participants anticipate that the interest rate tightening cycle may be nearing a pause or completion. For instance, the spread between overnight money and the six-month U.S. Treasury Bill narrowed from more than 60 basis points in early 2005 to nearly 15 basis points recently (see Exhibit 2). Consequently, value is determined by weighing market expectations versus internal expectations. However, based on this recent narrowing of the short end of the yield curve, the risk is that the FOMC continues to raise the target rate past current expectations. In this scenario, the ultra-short end spectrum is the most attractive.

Exhibit 2 Six-Month Treasury and Fed Funds Rate

MBIA Asset Management: Exhibit 3 shows the typical interest rate spread between overnight money and LIBOR (index used to price most money market products).

Of course, there are often exceptions to these historical relationships. The one- and three-month areas generally don't deviate that far from their norms, whereas the six- and 12-month areas do experience greater volatility. The short end of the yield curve is very sensitive to expected movements in the overall Fed Funds rate. The longer end of the curve is less sensitive to Fed rates and takes more of the overall economy into account along with other technical factors. The best value in the short end can be found in the one month area of the curve and the nine- to 12-month area of the curve where there is some steepness. The belly of the curve currently presents little relative value given current market expectations of the Fed Funds rate level expected by the end of 2005. The longer end of the curve is probably best managed by maintaining a very moderate short or outright neutral position due to the uncertainty of economic growth and inflationary pressures in 2006.

Public Investor: What is the relative risk and reward for investing in commercial paper right now at this end of the spectrum?

JPMorgan Asset Management: Well, local and state governments typically do not have the staff to do their own credit analysis so they are relying on the rating agencies for credit opinions. Provided the rating agencies are doing their jobs, you can pick up a decent amount of yield by moving into commercial paper. While commercial paper has gotten a bit more rich to Libor, it is not nearly as rich as Agencies and T-bills. So compared to other options, commercial paper actually looks pretty attractive.

Fifth Third Bank: Commercial paper currently offers a relatively beneficial risk/reward relationship versus other traditional investments in this ultra-short spectrum. For instance, the historical spread between top rated (A-1+/P-1), 30-day commercial paper versus one-month U.S. Treasury Bills and U.S. government agency discount notes has widened to approximately 30 basis points and 10 basis points, respectively in 2005 from 15 basis points and 5 basis points in 2004. Exhibit 4 displays the steady climb in yield for commercial paper securities since mid 2004 versus the volatile and widening spreads for U.S. Treasury Bills. Asset-backed commercial paper would provide an additional yield advantage on both an absolute and risk-adjusted basis. The beneficial relationship of commercial paper has been driven by an overall reduction in supply for both U.S. Treasury Bills and U.S. government agency discount notes.

Exhibit 4: Commercial Paper Versus U.S. Treasury Yields

MBIA Asset Management: Commercial paper with maturities of less than 60 days will present an opportunity to pick up 2 to 5 basis points when compared to other generic money market instruments (CDs, time deposits, U.S. government agency discount notes, Treasury Bills and Notes). Commercial paper supply has been ample inside of 60 days recently and issuers have been increasing their supply by about 6 percent compared to the previous year. (Supply had been decreasing in 2003 and 2004). The risk largely lies in the interest rate risk that is inherent across the whole yield curve at this time.

¹Note: The responses by JPMorgan Asset Management are intended solely to report on various investment views held by this firm. Opinions, estimates, forecasts and statements of financial market trends that are based on current market conditions constitute the firm’s judgment and are subject to change without notice. Return to reference point

Fed Chairman Greenspan to Retire; Bernanke Vows to Continue Course

A fter serving 18 years as Fed chairman, Alan Greenspan is planning to retire on January 31, 2006. Greenspan has served five terms as Fed chairman, and has held the post during four presidents—Reagan, Bush, Clinton, and Bush. He is 79 years old.

President Bush recently nominated Ben Bernanke, the current chair of the President's Council of Economic Advisors, to replace Greenspan as Fed Chairman. Bernanke is well respected in the financial community and was seen as the most likely replacement in a recent survey of economists conducted by the National Association for Business Economics. Prior to his appointment as chair of the Council of Economic Advisors, Bernanke was chair of Princeton’s Department of Economics and served as a member of the Federal Reserve Board of Governors.

It is likely that the change in the status quo to a new Fed chairman will increase the level of uncertainty in financial markets, at least until the new chairman establishes the same credibility as Greenspan. Bernanke helped to reduce some of this uncertainty by stating that his “first priority will be to maintain continuity with the policies and policy strategies established during the Greenspan years.”

Exhibit 1: Fed Funds Rate during the Greenspan Era

Fed Holds Conference on Payment Innovations

The Federal Reserve Bank of Chicago recently hosted a conference focused on electronic payment technology and other new developments in the payments industry. The conference brought together representatives from throughout the payments industry, including corporations, financial institutions, payment networks, third-party processors, the academic community, law firms, merchants, and solution providers.

The purpose of the conference was to explore why certain payment innovations have been more successful than others. Three main forces affect the nation’s use of more efficient electronic payment methods: (1) innovations in technology, (2) incentives that are strong enough to convince a large number of users to switch to a new payment method, and (3) government regulations that remove barriers to the widespread adoption of efficient payment mechanisms.

The following are some key observations from the information shared during the conference:

• A new payment mechanism is unlikely to be widely used unless participants on both sides of a transaction (i.e., buyers and sellers) both benefit from its adoption.
• Payment alternatives to cash tend to be more successful when a benefit is given for using the alternative (or a penalty is given for using cash).
• Although there are electronic alternatives to paying small dollar amounts with cash, consumer usage of these alternatives remains limited.
• The most successful instances in which electronic payments have replaced cash have been in “closed-loop” environments (e.g., transit systems, university campuses, and military bases) in which customers are required to use stored-value cards.

Source: “Forces Shaping the Payments Environment: A Summary of the Chicago Fed's 2005 Payments Conference,” by Sujit Chakravorti and Carrie Jankowski, Chicago Fed Letter, October 2005, Number 219a, The Federal Reserve Bank of Chicago.

GFOA Web Site Provides Forum to Facilitate Hurricane Assistance

Although the hurricane has passed, the devastation remains in many Gulf Coast local governments. The GFOA has established a hurricane assistance bulletin board on the GFOA Web site at www.mygfoa.org to provide a means for local governments to help other local governments in areas devastated by Hurricane Katrina. Finance officials and others responsible for payroll, technology, and procuring goods and services can post their needs on this site and governments wishing to assist with some of these basic governmental functions can offer their assistance.

Several other state and local associations have also established forums to provide assistance to local governments:

• The National Institute of Governmental Purchasing
• The National League of Cities
• The Association of School Business Officials

Panel of Economists

Economists Provide Economic Outlook

This month Public Investor asked its panel of economists to provide their forecast of the economy over the next six months, commenting on economic growth, inflation, and interest rates.

John Silvia expects that economic growth will be slower, but will still grow at a decent pace of 2.75 to 3 percent over the next six months. He anticipates that inflation will rise, with the consumer price index at around 3.5 to 4 percent in the fourth quarter. Silvia also predicts that interest rates will rise as the Fed raises rates over the next several months.

Lacy Hunt predicts that additional hikes in the Fed Funds rate will boost short-term interest rates, but at the same time bond yields will fall. Hunt notes that this combination will expose the U.S. consumer (who is currently highly leveraged) to a “tightening vice of lower discretionary income, higher interest payments, and reduced money and credit availability.” He points out that this situation has a far broader significance than catastrophic weather events. Hunt expects that the current slowdown in economic activity will persist and undoubtedly worsen in the next six months.

Carl Tannenbaum anticipates GDP growth of 2.8 percent in the fourth quarter of 2005, but he expects the economy to rebound early next year with growth at 3.8 percent. Tannenbaum predicts that CPI inflation will average 3.5 percent in 2005, and then fall back to 2.3 percent in 2006. He expects that the Federal Reserve will continue to raise rates up to 5.0 percent by mid 2006. However, he expects long-term rates to remain low and for the yield curve to flatten and eventually invert by the end of the year.

Housing Sector Could Be Starting to Cool

Anecdotal evidence suggests that the red-hot housing market may be cooling off. According to Fannie Mae economists, “realtor groups in some of the nation's hottest housing markets have recently reported that unsold home inventories and average time on the market have skyrocketed.”

Consumer confidence dipped to a two-year low in October. The Conference Board, which administered the survey, attributed the drop in confidence to the recent hurricanes and high gas prices. Many economists expect that consumer confidence will rebound soon. In fact, a majority of the respondents to a recent survey conducted by the National Association for Business Economics (NABE) expect the recent hurricanes will have no impact on the sales/revenues of their firms.

Inflation Warning Signs

A recent survey by the National Association for Business Economics (NABE) suggests higher prices may be on the horizon. Respondents (who represent a number of industries) reported higher prices for the goods and services their firms bought and sold in the third quarter. Further, the respondents expect these prices to continue to increase in the next three months. In addition, respondents “found customers more accepting of, or more resigned to, price increases than they were earlier in the year.” These findings were similar to the Federal Reserve's “Beige Book” of current economic conditions, which reported cost increases in all Fed districts for inputs such as energy, building materials, and shipping. Several districts reported that the increased costs of inputs are being passed on to customers through higher retail prices.

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2-Year Treasury Note
30-Year Treasury Bond

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The information and opinions printed herein are from sources believed to be reliable, but GFOA makes no guarantee of accuracy. Opinions, forecasts and recommendations are offered by individuals and do not represent official GFOA policy positions. Nothing herein should be construed as a specific recommendation to buy or sell a financial security.