Not What It Seems

Ride My See-Saw

Most investors (and the general public) mistakenly believe that interest rates are interest rates. When the Fed raises the Fed Funds rate, all interest rates rise. When the Fed lowers interest rates, all interest rates fall. This is definitely not the case.

Short-term rates are directly influenced by Fed policy. The Fed controls (or at least greatly influences) short-term liquidity (think back to August and September 2007). But what about the long end of the curve? What determines long-term rates? This can be answered in one word inflation.

Long-term rates reflect the market's inflation expectations. Long-term rates are only influenced by Fed policy in as much as Fed policy influences inflation. Here is what typically happens during a Fed easing cycle.

Woolly Bully

The economy begins to falter for one reason or another. Long-term rates begin to fall in anticipation of reduced inflation pressures. This causes the curve to flatten or, in extreme cases, invert. This is where the idea that an inverted curve foretells a recession was born. In reality, it isn't foretelling anything. It is reacting to economic conditions which are already materializing.

In response to the slowing economy (which is usually accompanied by waning inflation pressures), the Fed begins to ease. At this time, an inverted curve will begin to flatten and a flat curve will begin to steepen. When a yield curve steepens because of falling short-term rates, it is called a "bull steepener" It is called "bull because it because prices of short-term treasuries are rising. Usually, at least since Paul Volcker, the Fed is successful. What comes next is "the bear"

Grizzly Bear

If the Fed is successful, it's more accommodative policies should promote growth. Along with growth should come some measure of inflation. What is almost certain to follow are inflation fears. As investors become concerned with mounting inflation pressures, they are reluctant to lock in on the long end of the curve. Why lock in at lower rates when higher inflation will erode real returns? Investors demand higher rates of return on the long end of the curve to account for higher inflation. This causes long-term rates to rise. This is a bear steepener. It is a bear steepener because prices of long-term treasuries are falling. For this reason, some capital invested in long-dated treasuries is moved into growth investments. So this is a trend toward higher inflation, a steeper yield curve and higher long-term rates, right? Wrong. Since Paul Volcker, the Fed has displayed great vigilance when it comes to containing inflation.

Note: The fundamental definition of a bear steepener is when long-term rates rise more than short-term rates. A bull steepener is when short-term rates fall more than long-term rates.

Here Comes The Fed

The Fed, in an attempt to corral inflation pressures, begins to tighten (raise Fed Funds rates). As the Fed does this, the curve begins to flatten. This is a bull flattener. This will continue until the Fed is satisfied that inflation has been quelled. However, since the Fed typically overshoots to varying degrees, the economy eventually slows and the cycle continues.

Where are we now in the cycle? Well, by many accounts we are still in the Fed easing cycle. However, we are possibly approaching the point at which the market becomes concerned that inflation pressures will build and we could see higher long-term rates (the transition from a bear to a bull steepener). Look What You're Doing

Many investors reaction to this is to abandon the long end and buy treasury bills (thereby creating the bear steepener they fear). Though we agree that investors may not want to invest in long-dated treasuries, we believe that purchasing treasury bills at current levels is less than optimal. Unless Mr. Bernanke permits inflation to roar out of control for the sake of growth (not very likely), long-term rates will probably not rise enough to make investing at treasury bill rates below 2.00% a prudent decision. What are investors to do?

Conservative investors can ladder or barbell. One need not barbell the extreme ends of the curve. Barbells from 6-months to five years or two-years to 10-years may prove to be advantageous. One need not equally weight the ends of a barbell.

Ladders may be better options for more conservative investors as they are more resistant to changing yield curves and can be weighted in a variety of ways. Conservative investors should consider agency bonds as well. As we have said before, agency bonds are not in any kind of trouble. Moderate investors can not only play the changing shape of the yield curve, but also the changes of credit spreads. The Gate Is Straight, Deep and Wide. Break On Through To The Other Side

Credit spreads also change with the cycles of the economy. As economic conditions worsen, credit spreads tend to widen. This is why yields of corporate bonds and preferreds do not follow treasury yields basis point for basis point. In fact, they can often move in the opposite direction. This is what has happened in recent months. The more cyclical the business sector, or if the news from a sector is especially troubling (like the financial and housing sectors), the greater the spread widening.

When the economy turns around, credit spreads should tighten. Bonds whose yields moved higher when treasury yields fell (spread widening) could experience stabilizing or falling yields as business prospects improve. This is spread narrowing. Many investors get greedy and purchase bonds with the widest credit spreads, often without knowing the complete story on the issuer, in an attempt to capture the most gain on the recovery. We take a different approach to playing a spread narrowing.

We prefer to look for the widest spreads among high-quality bonds. Our reasoning is that, though there could be more upside potential with a junk bond during an economic recovery, there also could be a greater chance of default before a recovery gains traction. This is the reason we are proponents of purchasing preferreds and bonds issued by Merrill, Wachovia and Lehman rather those issued by Hovnanian, KB Homes and Standard Pacific. We have already seen Technical Olympic file for Chapter XI protection, along with a host of smaller builders. Though the potential reward looks attractive in the high yield sector, the risks are significant. During the past several years, corporate defaults sank to below 1.0%. The slowing economy could help that number rise to its historical levels of over 4.0% (or beyond).

We believe that fixed income investors with moderate risk tolerances would do well to invest using a laddered or barbelled strategy. Using agencies (or certain bank vehicles) on the short end, transitioning to corporates and preferreds as one goes out on the curve, could give the best bang for the buck and leave investors properly position for the next change of the economic cycle.