HomeMy WebLinkAboutHandouts_Pension Public Safety_Tab 03_08/03/2009~ + '~ ~
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Fixed Income Outlook - ul 2 009 ~ ~ ~ ~ ~-
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As we mentioned in our Second Quarter comments, we characterize the current environment as one with "low visibility." One can make a strong argument
for both economic resurgence and continued recession. As a result, our client portfolios are rather "neutral" with respect to sector allocations and durations
relative to their assigned benchmarks.
While the direction of the economy and interest rates is quite uncertain over the intermediate term, we do feel that ultimately, when the economy rebounds,
we are likely to see sharply higher Treasury yields and higher inflation.
Investors are rightly concerned about the tremendous amount of liquidity that the Fed has injected into the banking system. The Fed, on the other hand,
continually offers assurances that they have the mechanisms in place to "shrink" the Fed balance sheet and drain liquidity from the banking system in order
to prevent inflationary pressures from building.
We have no doubt that the Fed has the technical expertise to drain reserves in order to prevent the economy from overheating. The vital question is: does
the Fed have the intestinal fortitude to drain reserves in a preemptive manner. Will the Fed take away the punch bowl in the face of howling politicians and a
president coming up for reelection? To be clear, if the Fed is to nip any inflationary pressures in the bud, it will have to do so before the data clearly shows
that the economy is cooking again. If the Fed waits until all lights are green, it will be too late and the inflation genie will be out of the bottle. Frankly, we
have grave doubts that the Fed will have the guts to make the unpopular moves that will be required to navigate this inflationary minefield.
In addition, given the ballooning federal budget deficit, bond investors fear the tidal wave of Treasury bond issuance that will be required to pay the bills.
Many analysts expect interest rates to soar as an inducement for investors (especially foreigners) to take down this unprecedented amount of debt. For the
12 quarters ended September 2008, only once did foreigners fail to purchase an amount of US Treasuries equal to 100% of all issuance. For Q1 2009,
foreigners purchased only 24 percent of the Treasuries issued. In other words, domestic investors had to take down 76% of the Treasuries sold in Q1. As
the amount of Treasury issuance continues to grow, the upward pressure on yields will continue to increase.
In summary, the economy may indeed falter in the near term. Housing prices continue to fall (even though sales appear to be stabilizing) and commercial
real estate continues to slide. Unemployment is approaching 10%, and consumers are reluctant to spend. So, interest rates could fall in the near term.
However, barring a major shift toward restraint in government spending and an unlikely resurgence in Fed fortitude, we look for interest rates to move higher
sometime in the latter half of 2010 as the economy begins to rebound. In this environment, longer term fixed income securities would underperform those
with shorter final maturities.
ROCKWOOD CAPITAL ADVISORS
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