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Thursday, February 3, 2011

The Bond Market is Always Right! (published in March of 2010 in the SB News Press)

Over the twenty years I have been managing money for clients, there have been several times when the stock, bond, commodities, and real estate markets have moved in different directions (temporarily).  When this occurs, investment professionals and independent investors alike try to determine which direction the markets will move next.  In my opinion and experience, the bond market is always right, meaning that, whatever direction the bond market goes, the rest tend to follow.

To be more specific, I am not saying that all of the markets move in the same direction at the same time, or in other words, that if the bond market starts to move higher, all other markets also move higher.  Rather, what happens is that, whatever overall market and economic conditions that the bond market is predicting tend to be what really happens.  And, based on this prediction, the various markets move according to how you would expect them to react to those market and economic conditions. 

An example will probably make more sense… back in early 2007, when real estate and stocks were still pushing ever higher, the treasury yield curve went inverted, which means that shorter-term yields were above longer-term yields.  (Normally, yields are higher, the longer the maturity—you get paid more for tying-up your money longer.)  Many studies have been done on the implications of an inverted yield curve, but in essence it predicts that the economy will go into a recession within the following four quarters.  Indeed, within four quarters from early 2007 (in December of 2007 according to the official record) we entered a recession.  Historically speaking, the yield curve is the most accurate economic predictor I have ever seen, and as far as I know, it is the most reliable, period. 

Fast forward to today and we have a very steep, positively-sloped yield curve (longer yields are higher than shorter yields, (the normal condition for rates).  The steepness of the yield curve is extreme right now, meaning that the difference between shorter rates and longer rates is very high, and is much higher than the historical averages.  For example, the ten-year treasury is yielding about 3.7% while the two-year is yielding about 1%, for a difference of 1.7% or 170 basis points.  Not only is this a much larger difference than the historical average (about 1% or 100 basis points), but because rates overall are at historically low levels, the magnitude of this difference is even greater.  Or, to put it another way, the implications and predictive value of the steepness of the yield curve are even more powerful.

There are several key implications of a steep, positively-sloped yield curve.  One is that the economy is going to recover.  We already know that the economy started to recover in the third quarter of last year (the yield curve did, indeed, go to a positive slope before this recovery started).  The real question on this front is; does this recovery have legs?  I have written quite a bit in recent weeks about the possibility of a double-dip recession, and I have concerns about whether we will see a sustained recovery.  My feeling is that we will see the recovery continue, but that the pace of the recovery will be very slow; anemic in fact.   

Another implication of the steep yield curve is that interest rates are going to move higher, especially on the shorter-end of the curve (for shorter maturities).  Because rates are so low right now across the entire curve, and because the Fed has taken rats down literally to zero, there is only one direction for rates to go, which is, of course, up.  The real question here is; when will they start to move higher and how high will they go?

The Fed (Federal Reserve) is in a very tough spot—if they raise rates too quickly, they will kill any chance we have at a sustained recovery; if they raise them too slow, they could allow inflation to take root and get out of control.  This brings up another key implication of a steep, positively-sloped yield curve, which is that inflation is coming.  How much and for how long is not clearly defined, by we can say that, at least from a yield curve perspective, we should see inflation heating up shortly.

If the Fed can find the perfect pace of interest rate increases that fosters economic growth while, at the same time, curtailing inflation, then the economy can have a sustained recovery and we all live happily ever-after.  The reality, unfortunately, is that there is probably no perfect pace of interest rate increases that would result in this ideal outcome.  Instead, it is more likely that the Fed will have to make the tough choice between economic growth and fighting inflation.  History has shown us that when the Fed has to make this choice, they choose to fight inflation because the consequences of runaway inflation are far worse than a weak economic recovery or even another recession.

What can we expect from the markets?  Regardless of whether long-term or short-term bond prices move more, virtually all bond prices would move down in a rising interest rate environment.  Bond investors in this kind of environment would want to shorten maturities by selling longer-maturity bonds, hopefully locking-in relatively high prices on the bonds that are sold, and then purchase shorter-maturity bonds (usually five year maturities or shorter).  

(Each investor must determine the appropriate strategy to follow and should consult their tax and financial advisor before making any financial decisions.)  These shorter-maturity bonds should then be held until maturity, at which time, if rates have risen, new bonds could be purchased at higher yields.  Over time, as rates continue to rise, the portfolio would generate an increasingly higher overall yield.  Once rates top-out, maturities should be lengthened to the longest maturities that are appropriate for the specific investor’s objectives and risk tolerance.

For bond portfolios, I use a laddered approach, meaning simply that I invest a certain portion of the bond allocation of each portfolio in each of four or five maturities so that I have money coming in each year or every few years, which can then be reinvested.  As an example, and under our rising rates scenario, I would have bonds with maturities of 1, 2, 3, 4, and 5 years. That way, at the end of each one-year period, bonds would be maturing, providing me with funds to reinvest, hopefully at ever-increasing rates.

For stocks, a rising interest rate environment is not necessarily a bad thing, as long as rates don’t move up too quickly.  The same could be said for commodities and for real estate.  In fact, a little inflation is actually good for all three markets.  The problem will come if inflation heats up too quickly and the Fed slams the door by raising rates rapidly and by a significant amount.  This would be bad for stocks and really bad for real estate and commodities.  Rising rates would strengthen the dollar, which would pressure commodity prices heavily, and the stronger the dollar, the more downward pressure we should see on commodity prices. 

For real estate, higher rates are obviously a huge negative, as they make mortgages cost more.  This would likely reduce activity and force prices to adjust down even further to make properties affordable for borrowers. 

Of all the markets, I would want to focus on stocks and bonds.  I would keep maturities on bonds to five years or less, and I would only buy stocks at attractive valuations, which means I will have to wait for a substantial correction from current levels before I would feel comfortable buying any stocks.  Even then, I would be very choosy about which companies I bought and within which sector of the economy I would buy them.  I would focus only on the highest quality companies with dominant market-share, products, clean balance sheets, great management, good credit, etc., and I would only buy companies in those sectors that have growth rates superior to the overall market, and which historically do well under the expected economic conditions.  This would include technology, financials, industrials, and consumer discretionary companies.

Next week I will look at our local wineries, at how they are using sustainable approaches to running their businesses.

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