A Taste of Honey

The following is an excerpt from our daily commentary. Subcrivers get this and much more: The economy is constantly evolving. Although there are some traits common to economies which have existed during the 236 years of U.S. history, there have also been great differences. “Things” don’t just happen. This is why we are critical of technical analysis over the long term. Although data and patterns can be used to great effect in the near term, once there are structural changes to the economy and secular changes to markets, technical analysis (without considering the context of the times) is much less useful. With this in mind, we believe that the FOMC will extend its guidance for extraordinary policy accommodation until, at least, 2015 and could announce open ended bond purchases (probably focused on MBS). The first actual Fed Funds rate hike might not come to a year or more after that. However, that assumes that domestic fiscal policies remain dysfunctional and global economic conditions remain impaired. Although this is our base case scenario, we are not so audacious to state with certainty that, economic conditions will remain impaired for the next three to five years. It is also not a certainty that the Fed will do anything more than jawbone today. We believe that the best way to position for the next several years is to ladder portfolios, focus investments on the five-year to seven-year area of the curve, but having an adequate portion of one’s portfolio in the in the two-year to four-year area of the curve, as well as on the 10-year to 15-year area of the curve. What percentage of one’s fixed income portfolio should be place on specific areas of the curve? That depends on investors’ goals, objectives and risk tolerance. We like the so-called belly of the curve (intermediate portion). We would tend to underweight the short end of the curve, overweight the intermediate portion and have moderate exposure out to 15 years, but this is gross generalization. Portfolios should be constructed to match investors’ needs. As we speak with market participants and investors, we pay close attention to their fears. Investors tend to fear inflation and rising rates. This is mostly due to concerns that the Fed will be slow to react to a strengthening economy or that Fed money printing will lead to devaluation-related inflation. However, market participants fear that the Fed will run out of options to fuel the liquidity-related strength in risk assets and to keep the economy above water before fiscal policy makers adjust policies to reflect new realities. We are in the market participants’ camp. We would be thrilled if the biggest problem we faced was repositioning portfolios to reflect strong growth and related inflation pressures. However, we believe that to be an unlikely scenario for the near future. We do not put much credence in a weak currency inflation scenario. The rest of the word is in the same boat. The worst thing for many export-driven economies is for their home currencies to weaken versus the dollar (listen to the noise emanating from Japan). They will do what they can to support the dollar. The U.S. dollar could exhibit some weakness in the near-term, but as with QE1 and QE2, the dollar will find support rather quickly. It is for this reason that we believe that Fed policies are creating trading opportunities, rather than investment opportunities, in risk assets, such as equities, high yield debt and metals. These trading opportunities may perform well for six months, a year, maybe longer, but we do not see the foundations for long-term secular bull markets in these asset classes. Even if the “Fiscal Cliff” is avoided, necessary spending cuts (and probably some tax increases) will place a drag on the economy. A shrinking labor force and less affluent retirees could result in less consumer spending than in the past. The U.S. economy will continue to evolve and adapt. This could feel painful at times, but it is a necessary process. As the Theory of Evolution teaches us; it is adapt or die. Follow us on LinkedIn by joiningg the Bond Squad group. It is open to everyone. Tom Byrne tom@bond-squad.com. www.bond-squad.com www.mksense.blogspot.com 347-927-7823 Twitter: @Bond_Squad Disclaimer: The opinions expressed in this publication are those of the author. They are not, nor should they be considered solicitations to purchase or sell securities.