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Bond Market Watch

Our Monthly Bond Investment Strategy Guide

May 2008 (will resume in July)

Inflection points in the financial markets can be challenging to identify and even more difficult in terms of positioning (or repositioning) a portfolio appropriately. One of the current financial market debates is Federal Reserve policy and -- specifically -- if the Federal Open Market Committee is at a terminal point for this easing cycle. The employment outlook and housing sectors of the economy remain weak, and manufacturing (as measured by the Institute of Supply Management Index) has contracted in four of the past five months. In addition, the Fed has lowered the target federal funds rate (the interest rate at which banks lend to other member banks) seven times since September 2007, a total of 325 basis points (bps). The federal funds target rate now stands at 2%. (Note: 100 bps equals 1%.)

This action and other measures (i.e., the Treasury Auction Facilities) have been in response to the weakening economic outlook and ongoing financial market turmoil. However, recent comments from various Fed officials indicate the Fed may be at a stopping point in terms of lowering rates. In separate speeches on May 13, 2008, Federal Reserve Bank of Kansas City President Thomas Hoening and Federal Reserve Bank of Dallas President Richard Fisher both weighed in with inflation concerns. Other Fed officials have voiced similar thoughts in recent appearances.

With the substantial interest rate cuts already in place, fiscal stimulus in the form of tax rebates, and the Fed's additional liquidity measures to address ongoing stress in the financial markets, we think the Fed is at a stopping point for this cycle. That view is confirmed by the current implied rates from the fed funds futures market, which currently price a high probability (approximately 90%) that the Fed is on hold through the summer with the odds slightly favoring a quarter percentage point increase in the fourth quarter of 2008. In our opinion, it is a little early to start forecasting interest rate increases, but it is time to think about the implications of the end of the easing cycle.

One of the first questions most investors ask at the end of an easing cycle is when will the Fed reverse course. Looking at the Fed cycles beginning with the easing cycle that ended in December of 1971, the average time elapsed between the last Fed ease and the first Fed increase is approximately 11 months. However, each cycle is unique with as little as two months and as much as 17 months between the changes. Though this is interesting information, the behavior of the credit markets is more important to fixed-income investors.

With duration as the biggest driver of performance for fixed-income investors, understanding the yield curve shape and how benchmark Treasury yields act at the end of a cycle are more important than what the Fed will do next, in our opinion. Historically, the benchmark 10-year Treasury (on a yield basis) bottoms near the end of an easing cycle. During the past nine easing cycles, in five instances the yield actually bottomed prior to the last Fed easing, albeit sometimes by just days. More important, in each case the yield on the 10-year note hit its lowest level well before the Fed actually began raising rates. In the current cycle, the lowest yield on the 10-year note was 3.31% on March 17, 2008. The Fed has lowered rates twice (totaling 100 bps) since then. Barring another major "tape bomb" from the financial sector, we believe we have seen the low in yields for this cycle.

Historically, the yield curve also has a tendency to flatten after the Fed finishes an easing cycle. Using the past nine cycles as a sample and looking at the yield curve (10-year Treasury less two-year Treasury) six months later, it has flattened in seven of the nine cycles. However, we should point out that it has been the two most recent cycles (that ended with an easing in November 1998 and June 2003) that have gone against the trend with the curve 14 and 22 bps steeper, respectively. In the current cycle, the yield curve has already flattened significantly. After peaking at 209 bps, the 10-year versus two-year spread has narrowed to 141 bps currently. A portion of that is attributable to a reversal of the flight-to-quality bid and a portion is the market forecasting a change in the outlook for Fed policy.

Credit spreads (the difference between Treasury securities and non-Treasury securities), which have already narrowed slightly relative to Treasury benchmarks, have a tendency to converge at the end of an easing cycle. Looking at our sample of the past nine cycles and the behavior of credit spreads (Moody's Baa less Moody's Aaa), we can see that three months after the last ease spreads converged slightly more than half of the time. However, the trend is much stronger six months after the last move in an easing cycle, with credit spreads tighter in eight of nine instances. In the current cycle, both Aaa and Baa credits have tightened significantly relative to Treasuries and have converged to a lesser degree.

If, and as, evidence grows that the Fed is finished with this easing cycle, investors may want to keep some of the aforementioned historical trends in mind. As evidenced by the firm's Cyclical Asset Allocation models, we continue to position fixed-income portfolios defensively in terms of duration and are moving more towards credit instruments. In particular, investment-grade corporate bonds are attractive relative to historical valuations. Non-investment grade bonds, also referred to as high yield or junk bonds, are also interesting and we recently increased allocations slightly to this area. However, with the economy and financial markets still fragile, we would remind investors interested in this asset class that there are higher risks as well as sensitivities to both the economy and liquidity.