When viewed over a span of decades, it becomes clear that the direction of interest rates is highly correlated with inflation. Thus, any successful attempt to forecast interest rate movements must also be an attempt to forecast inflation.
Although it is intuitively logical to assume so, inflation is not necessarily a product of a strong economy. When real gross domestic product is compared to inflation, one can quickly see that they travel in opposite directions as often as they track each other. The relationship appears totally random. A cursory glance around the world reveals that some of the weakest economies have some of the highest rates of inflation. The United States has not been immune to this occurrence either. During the recessions of 1974-75 and 1980-81, the country experienced double-digit inflation.
Rather than being an economic phenomenon, inflation is always and everywhere a monetary phenomenon, as Milton Friedman famously stated. My best proxy for discerning monetary policy as it relates to inflation is the monetary base. Beginning in January 2001, the Federal Reserve has steadily accelerated the growth rate of the monetary base. Twenty-two months later the compound annual growth rate of the base has reached 8%.
This proactive approach by the Fed was prompted by the bursting of the stock market bubble and the subsequent terrorist attack--both of which have served to hinder the economic recovery.
Responding to past monetary policy, the current rate of inflation in the United States has fallen to below 1.5%. At such low levels, many bond managers have begun to debate the prospects for deflation--akin to the situation in Japan. In my opinion, this worry is for naught. In a recent television interview, Friedman responded to a question about the prospects for deflation by saying that the central bank knows how to stop a deflation and would do so.
Our model indicates that inflation will probably trough in the fourth quarter of 2002 and trend upward throughout 2003. Oil prices are an independent variable in this equation and they cannot be reliably forecast. Oil has demonstrated that it can even temporarily override the inflationary effects of monetary policy if its price moves are substantial.
With tensions rising in the Middle East, there is always the possibility of a price spike, which could amplify the inflationary stimulus of monetary policy. While the converse is also true, our model suggests it would require a drop of over $20 per barrel to overcome the current monetary stimulus.
With so many different factors pointing to rising inflation, I believe bond managers should consider assuming defensive postures within their portfolios. Reversing course from recent years, managers should consider shortening durations to less than their chosen benchmark. In our portfolios, we have shortened to a 2.75-year duration (down from a 4.75-year duration in recent years) and we may even move to a 2.0-year duration in the latter part of the year.
Bond managers with TIPS positions should also reevaluate those holdings. TIPS are an investment vehicle that we have advocated for the past three years. We acquired significant positions when these securities paid investors 4.25% plus inflation in 1999 and appeared highly undervalued. We had expected to increase our position in these securities as a hedge against rising inflation in 2003.
But it is clear we were not alone. As interest rates in general have fallen, these bonds have increased in popularity, rising in price until they recently yielded only 2.2% plus inflation for a 10-year maturity.
At thist point, we believe TIPS have substantial price risk despite their inflation protection and thus have eliminated them from our holdings.
Today investors face a difficult choice between longer maturities that have greater income but greater price depreciation risk or shorter maturities that provide minimal income. In our opinion, taking the more difficult path with short maturities is the correct strategy to maximize total return in the rising rate environment that we foresee.
"In our opinion, taking the more difficult path with short maturities is the correct strategy to maximize total return in the rising rate environment that we foresee."
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