| The opinions referenced are those of the Core Plus Fixed Income team as of March 18, 2008 and are subject to change at any time due to changes in market or economic conditions and may not necessarily come to pass. These comments are not necessarily representative of the opinions and views of the firm as a whole. The comments should not be construed as recommendations but as an illustration of broader themes. Hello this is David Armstrong of the Core Plus Fixed Income Fund and I would like to comment on today’s monetary policy meeting at the Federal Reserve and maybe talk about the context in which that decision was made both from a market standpoint of fixed income markets and from an economic standpoint.
At the meeting the Fed lowered the funds rate from three percent to two and a quarter percent and lowered the discount rates to two and half percent. In the statement accompanying the decision the Fed mentioned a continued risk to growth, negative risk to growth, and also voiced some increased concerns about inflation. Now on its own the inflation concern would lead you to think that perhaps they’d be raising rates. And on its own the growth risk would lead you to think that they were perhaps prone to easing rates further.
It seems pretty clear from reading the statement that the growth risk, the negative risk to the economy, outweighs the inflation concern and we should assume that the Fed has a continued bias to ease rates.
Rates now are two and a quarter percent and market expectations of long-term… the long-term funds rate a fair level if things in the economy were balanced would be about four and half percent. So it’s clear that this funds rate is very accommodative. And let’s talk about some of the reasons on why that is and why the period of accommodation will probably extend out at least a year and perhaps the Fed will have to ease further.
You know, in my 20 plus years in fixed income I think the challenges to the consumer right now are maybe as difficult as any I’ve seen. If we just want to tick off a few of the things that consumers are thinking about right now, one is, of course, their house is probably… the value of their house has probably declined so they have a reduced net worth. Employment growth in this economy has stalled out since the fourth quarter of 2007. Lending standards have been tightened and, of course, you’ve got the shock to energy prices.
So that’s a real set of challenges for the consumer. And that, of course, leads to declining demand for businesses at a time when they see their own stock price declining and, of course, credit spreads are widening so they’re experiencing difficulty in getting the loans they need. So the consumer and business backdrop is a real challenge. And when you look at the finance and banking system they’re in the process of trying to figure out what assets are worth on the balance sheet and in the process of reducing their balance sheets.
Normally when the Fed reduces rates this much and the yield curve steepens as it has, banks are fairly quick to begin adding assets to their balance sheet because they can take deposits, carry of financing at a low funds rate and then maybe adding mortgage-backed bonds or what have you to their balance sheet and earning that positive carry and adding to their earnings.
Well that’s not happening at this point, of course, because banks are still in the process of reducing their balance sheets. So there are challenges both in the banking system and the business front and on the consumer front. And that’s why the funds rate is down to two and quarter and likely to continue lower.
On the inflation front I really feel like the Fed is talking tough on inflation but likely to do nothing about it. And I actually think that that’s warranted at the moment. And I know there’s a lot of criticism in the papers about the Fed ignoring the risk to inflation. But if you look back in 2003 they were very worried about the inflation and we felt in our investment group that that was not likely because we looked at how much aggregate demand was growing.
And aggregate demand was growing at that time at about four or five percent, which is above our long-term ability to produce goods, which is about two and half percent. So as long as the aggregate demand is growing faster than potential growth you’re going to have positive inflation rates. So we never thought all the fear about the inflation was warranted back in 2003.
On the other side of the coin now where everyone’s worried about increased inflation, if you look at the last year in aggregate demand growth it’s been about five percent and it’s been slowing. In the fourth quarter of 2007 it was three and quarter percent. And so let’s just assume that five percent is right as a trend, if we can grow at two and half percent and aggregate demand grows at five percent then inflation rates of about two and half percent over time make sense. I mean in fact that’s about – if you look at inflation swaps and inflation market – that’s about where the long-term inflation expectation is.
So as long as the nominal economy continues to slow and stay at these levels the inflation language from the Fed may be harsh but I don’t think it’s going to impact the decision very much. If aggregate demand were to pick up, which I don’t expect it to do, to six, seven, eight percent that would be a real issue. And that’s what happened in the 1970s. It is not happening today. So I think the focus should be on the Fed funds rate going even lower and staying there for a while.
The Fed has another challenge though and that’s to reduce liquidity spreads in the market. If you look at the relationship between interest rate swaps and Treasuries, corporate bonds and Treasuries, mortgage-backed securities and Treasuries you see that those spreads are very wide. And the Fed is fighting on that front through these special auction facilities that you’re reading about and also through direct lending to Wall Street. So they’re really fighting a battle on these two fronts, bringing the funds rate down, bringing the Treasury curve down, trying to cushion the drop in consumption, at the same time bringing these liquidity spreads.
The market today, actually counterintuitively yields backed up about 25 basis points at the front end of the yield curve. So two-year notes today are about 1.6 percent. That’s 25 basis points higher than yesterday. And, of course, the Fed lowered rates today so why did the market back up? Two reasons: One is the market didn’t like the tough language on inflation and the market also didn’t like that it wasn’t a unanimous vote, it was a vote of eight to two with I believe it was Dallas and Philadelphia both dissenting. And in addition, of course, there was… the market was pricing already for there to be a reduction in the funds rate today of at least 75 basis points and with some hope of 100.
So all of those three things together sort of disappointed the market. But as I say I think, I still think fixed income, especially Treasuries, will remain firm for a while.
In terms of Core Plus Fixed Income, I manage our interest rate strategies which are at the moment I would say a minor part of our risk budget when you consider that we have mortgage-backed strategies and credit strategies or corporate bond strategies. But we’ve been positioned to benefit if yield curves steepen which they have been. And we’ve been positioned that way throughout 2007 and so far in 2008 and that’s been a successful strategy.
There’s nothing that I see here in developments in the economy, in the markets or in communications from the Federal Reserve that makes me think that that’s not still a good strategy. So we haven’t changed our positions but we have a lot of confidence that yield curve steepening is still the trend in the marketplace.
If you look at recessions, which we may be in one now, it’s typical for market yields in fixed income to bottom out and for yield curves to be the steepest well after the recession is taking place. So if you go back to the 1991 recession the yield curve didn’t reach its steepest point I think until 1992. If you look at the 2001 recession I don’t think the yield curve reached its steepest point until 2003. And if we’re just starting into a recession now it’s quite likely in my mind that the low rates that we’ll see and the steepest curves that we’ll see are probably some time in the next two to four quarters.
Thank you very much.
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