Welcome to the third edition of the Huntington Steele newsletter. Thank you for your comments on prior editions; please keep them coming! Our goal is to continue to improve the educational content and format of these newsletters through time.

Best Wishes,
Patsy and Jen

A Tirade on Bonds

In the mid 1980’s at Salomon Brothers, the best and brightest young hires were offered positions in the bond department. The “kids” who could not pass the final exam in the bond module of Salomon’s training program had to settle for positions in the equity department. (These same individuals were later made famous through Michael Lewis’ book Liar’s Poker.)

The trading and commentary surrounding the recent rise in interest rates would suggest that Salomon’s strategy is still in practice in the wider Wall Street community. Let’s examine the facts of the case.
Since the early 1980’s, the US Government bond market has largely enjoyed a bull market. Although we have seen periods of rising rates, the overall trend for two decades has been toward lower rates. There are many factors that influence rates, but the circumstances surrounding the precipitous decline in rates in the past 12 months are perhaps as irrational as those surrounding the rise in the equity market of 1999.

In general, the supply and demand of US Treasuries is the single largest determining factor of bond market rates. Inflation is another important factor, as are exchange rates. The Federal Reserve sets interest rate policy with one tool – the Federal Funds rate. However, it is important to keep in mind that Fed Funds is a short-term overnight rate that banks pay to borrow from the Federal Reserve Bank. (Interestingly, the Federal Reserve was founded by Alexander Hamilton who was also the founder of our Master Custodian – The Bank of New York. As an aside for those interested readers, you may want to pick up a copy of “Hamilton’s Blessing” by John Steele Gordon. ) The Fed has very little influence over longer term rates. Longer-term rates are determined by market forces, with supply and demand as the primary influencing factor.
In this past year, it has been no secret that the US Government has begun to accumulate an extremely large deficit. We have moved from a surplus of $200 billion in 1999, to a current projected deficit of approximately $500 billion. Typically, when we know that the deficit is increasing, we see rates rise because there are more government securities that will need to be issued and sold. However, this past year saw the opposite phenomenon – we saw rates plummet in the face of an accelerating deficit. This phenomenon set the stage for the current historic bond market rate backup.
The question becomes then, why did rates go so low in light of what was clearly know information, and what are the implications for the financial markets. There are no doubt many suspects, but we would highlight four factors that were the primary conspirators: investor’s fear of further equity loses, their chasing of bond fund performance, mortgage backed securities managers, and Asian central bankers defense of their currency. All the while Stephen Roach, the Morgan Stanley lead economist was giving full and total credit to the bond market’s perceived fear of deflation. In other words, he and his followers believed that the reason that rates were declining was that the world finally understood that they were “right” and that the bond market was behaving rationally and adjusting to a world with persistent deflation. Well maybe, but as many of you know we have for these past 14 months not been recommending bond purchases. Fear trumps all in financial markets. Witness the amount of money in cash earning 1% or less. The only time that 1% looks attractive is when the alternative is to lose money and that is exactly what everyone is afraid of after these three difficult years. With 13 rate cuts as fuel, bond market performance in 2001 and 2002 was stellar, and the fund flows into bond mutual funds was enormous fueling even further rallies. Then came May of this year.
In prepared comments, Alan Greenspan said, that the Fed was prepared to use extraordinary means to fight deflation. Those means were specifically the open market purchases of US ten year notes. Stephen Roach and company hailed these remarks as further proof of their thesis, and the ten year note rallied from 4% on May 1st, to 3.11% on June 13th. The trouble was while Greenspan said he was prepared to use these means, Stephen Roach and company took it literally. This had enormous technical implications for the mortgage backed managers and for the Asian central banks. The mortgage managers had to buy an ever increasing amount of treasuries to offset the redemptions of their bonds as a result of heightened refinancing activity. And the Asian bankers wanted to support the US dollar so that their trade good would remain priced competitively, and thus they too were large buyers of treasuries. The rally was swift and stunning. On June 25th, the Fed cut rates for the last time by 25 basis points to 1%. Greenspan clarified his position on deflation and intimated that their expectation was for rising inflation and growth in 3rd and 4th quarters of 2003. Oops. There is needless to say no room for disappointment in a bubble and the reversal has been brutal. The economist and pundits say that Greenspan lied to them, but they simply heard what they wanted to hear. All of the technical factors were thrown into reverse and as of this writing; our ten year not has risen by 145 basis points, and dropped in value by $116,700 per 1mm in bonds.
Despite this historic reversal, long term rates are still at absolute levels last seen during Eisenhower’s administration. But to hear the pundits speak, you would never ever know it. While rising rates are never a long term positive for equity markets, we strongly believe that the low absolute level of rates will provide a perfectly reasonable environment for economic growth. Rates could even back up further from here another 50 basis points and only then would we be back to a more normal rate backdrop for an economy growing 3% or more.

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