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 May 2006 Yield to Bonds
Nevertheless, investors are just as conflicted as they were at the start of the year. This time the culprit's the bond market. After remaining flat to slightly lower in the first 18 months of the Fed's monetary tightening campaign, yields on longer maturities have finally started moving up -- and rather dramatically so. The 10-year Treasury Note began the year yielding around 4.4% but by mid-April it stood over 5%. Since prices move inversely with yields, many bond investors finished the month with year to date losses.
It's ironic that yields are moving now, just as the Federal Reserve is finally sending signals that they're almost done raising rates. According to the minutes of the March 27-28 FOMC meeting, "Most members thought that the end of the tightening process was likely to be near." Evidently they felt so strongly, when it came to the wording of the post-meeting statement, "Some members expressed concern that retention of the phrase 'some further policy firming may be needed to keep the risks...roughly in balance' could be misconstrued as suggesting that the Committee thought that several further tightening steps were likely to be necessary." So if that's truly the case, why are long yields moving now? Shouldn't they instead be poised for the traditional "end-of-the-tightening-rally"?
Two Sources of Inflation The first thing that comes to mind in this regard is energy. Contrary to what many economists had predicted, crude oil prices have persistently climbed in the first four months of 2006. Many had expected them to plateau around $60/bbl and perhaps even drift back down in the latter half of the year. Hopefully the final part of that forecast will still come true, but by the end of April prices were $10-15 higher than at the close of 2005.
This hasn't escaped the Fed. Indeed, the FOMC minutes note that, "Higher energy prices still seemed to be passing through to the prices of a number of core intermediate materials, although such increases were more moderate than those observed in the immediate aftermath of the hurricanes last autumn." But now, there appears to be a second source of inflationary pressure: the labor market. Declining unemployment (usually believed to be a good thing) coupled with the ongoing creation of new jobs suggests a tightening labor market. Prior to this, the demand side was the only source of inflation, but if the economy continues to steam ahead workers may find themselves in a stronger bargaining position, introducing the specter of supply side inflation. As the Fed's minutes put it, "[M]eeting participants generally remained concerned about the risk that possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, could add to inflation pressures." Actually reported inflation doesn't appear all that troubling. While it has begun to tick up at both the producer and consumer levels, at an annual rate of roughly 3½%, it doesn't pose an immediate threat to the ongoing economic expansion. In fact, if the Fed's actions do have the side effect of slowing the economy, that too, will tend to keep inflation in check. Perhaps that's why bonds have suddenly awaken from their 2-year slumber.
More in Store Many market watchers speculated Mr. Greenspan's conundrum could be attributed to the enormous inflow of foreign investment creating a demand for long-term bonds and ultimately supporting their prices. It's just simple supply and demand.
The foreign inflow is actually fueled by the current U.S. trade imbalance. As net imports grow, our trading partners find themselves with more and more dollars on hand. The best alternative has been to invest in U.S. government bonds, especially since U.S. rates have been higher than those in other countries. Ironically it's this foreign flow of funds that may ultimately keep U.S. interest rates rising even when the Fed finally steps aside. In fact, this at least partially explains what's been happening with long-term U.S. rates over the past month or so. During that time, various European and even the Japanese economy are coming back to life. For the first time in years, the EU and Japan aren't just talking about increasing short-term interest rates, they're actually taking steps in that direction. As foreign rates begin to rise, the U.S. will have increasing competition for investment dollars. At the same time, some Asian and Middle-Eastern countries are beginning to diversify their foreign investments, reducing the amount devoted to the U.S. As long as the U.S. remains dependent on foreign investment to help offset ongoing deficits, domestic interest rates will have to continue rising -- even without Fed intervention -- in order to remain globally competitive. That's definitely not what investors were hoping. Ever since the Fed started pushing rates higher, they've looked forward to that "end-of-the-tightening-rally". In the past, stocks and even short-term bonds have rallied when the Fed signaled they were done. Many thought this would be the catalyst for the next move up in the 4-year old bull market. It could still happen, but the recent jump in long-term yields has taken many by surprise.
Return to Normal
Monetary policy is still more of an art than a science and a great deal of that is due to the fact that there's such a significant delay between Fed action and its full effect in the economy. The Fed worries about this, too, as attested by the fact that the March FOMC minutes noted that some members, "expressed concerns about the dangers of tightening too much, given the lags in the effects of policy." In April, FOMC voting member Janet Yellen put it more succinctly, ""[I am] increasingly concerned about the well-known long and variable lags in monetary policy -- specifically, that the delayed effects of our past policy actions might impact spending with greater force than expected." Truth be told, monetary policy is a lot like throwing a stone into the middle of a calm pond. It may take some time, but eventually the ripples will make their way back to shore. After the Fed lobbed 15 quarter-point stones, we can expect a lot of ripples. The first are coming ashore now as long-term interest rates rise. This has an impact on equity as well as bond investors. What's got them concerned is the magnitude and cumulative effects of the 15 (and probably 16 by the time you read this) ¼-point rate increases. In the past, the Fed has tended to overshoot, raising rates too far and stalling the economy. At least some Fed members are aware of this, for as Ms. Yellen says, "I will be highly alert to the possibility of the policy tightening going too far." With rising oil prices cutting into consumers' disposable income and higher interest rates putting an end to the refinancing boom, consumer spending will continue to slow. Although greatly anticipated, corporate spending has yet to pick up the slack, and it ultimately may not if the economy markedly slows. In the short-term, an end to the Fed's tightening may spark the expected equity rally, but if high oil prices and rising long-term rates persist, it will quickly fade as we enter the seasonally slow summer period. Prospects for the traditional year-end rally will also be dependent on oil prices and interest rates.
A Different Defense
For three years now, pundits have expected these large cap growth stocks to rally only to see small caps and value stocks continue to outperform. While there's no guarantee that large cap growth will return to favor, they are, however currently more fairly valued (or in some cases, undervalued) relative to the rest of the market. As a result, they provide more upside potential as well as a degree of downside protection in the event of a market downturn. On the other hand, traditional defensive sectors such as Utilities may not play their usual role now. Utilities had a nice run in 2005 and are now falling prey to higher interest rates. They'll continue to be under pressure as long as energy prices -- their primary operating expense -- remain high. Consumer Staples may provide some downside protection given that they haven't enjoyed the run-up of the rest of the market, but growth and margins will be limited by climbing interest rates. They may provide a steady return, but in a higher interest rate environment, it may be surpassed by short-term bonds or even money market investments. Diversification is the other key to defense. With a slowing U.S. and reinvigorated foreign economies, increased foreign exposure can help. Caution is needed however, as foreign stocks have already become market leaders. The hottest of the hot have come from emerging market countries led by Brazil, Russia, India, and China. This is no longer a secret and stocks in these areas run the risk of becoming overvalued -- if not so already. Nevertheless, diversification through increased international exposure can help boost portfolio return. After three years of uninterrupted growth, it's probably time for U.S. stocks to take a breather. That doesn't necessarily mean a bear market or even a severe correction, although some sort of downturn wouldn't be surprising. It's hard to imagine a sustained move up as long as rising oil prices, interest rates, and geo-political tensions persist. While it would be nice for the Fed to step aside, that won't be enough to lead to a sustained rally. That will only happen when some of these other issues are resolved, perhaps as early as later this year. Until then, defense and diversification remain the key. Search this site! Just enter you key word or words:
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HE U.S. ECONOMY REMAINS remarkably resilient. After a brief pause in the hurricane-slowed fourth quarter of 2005, it was back on track in the first quarter of 2006. Earnings once again came in with double-digit gains with most surprises on the upside. Unemployment fell to 4.7% while new jobs were created at a sustainable pace.
