 |
| Paul O'Brien |
What's your view on interest rates?
We think interest rates will rise faster than most people think and that the yield curve doesn't fully price it in. Today's yield curve allows at most for 3 1/2% by December and another quarter point in 2006. When we look at economic data, inflation is drifting up and growth is solid. We think the market would be more fairly priced if it allowed for a 4% rate by the end of the year and 4 1/2 or 5% in 2006.
This makes me particularly cautious on securities on the front end of the yield curve, which is the most sensitive to a market repricing of its expectations. The economy has slowed a bit but the only problem seems to be the running up in energy prices. There are low rates, narrow credit spreads, business confidence is solid and employment growth seems to be well maintained. We could easily have a wiggle, but I'm still expecting growth to remain around the 4% level of 2004. That would mean the [Federal Reserve] is likely to move up 25 basis points a meeting.
Would you be surprised to see the Fed move rates up by 50bps?
I would not. The Fed probably wouldn't mind if the market thinks it might. The key question is inflation. In my opinion, 25bps will get us caught up fast enough to 4 1/4%. If the PCE deflator is poor, they might pick it up. We might see it in June or August.
Why is everybody focusing on inflation as the central concern?
We have reached the stage of the business cycle where it has matured and this is the time when fixed-income investors have to be on the lookout for rising inflation. It has risen substantially and the Fed wanted inflation to rise. It is certainly a risk that inflation will continue to rise. Projections from last February have the Fed looking for inflation to be up to 1 3/4% through 2006. We're almost there and the Fed doesn't have much room. Inflation is difficult to forecast, but for the Fed, for its credibility, keeping inflation low is important. If it hits the top of their band, I would expect the Fed to respond forcefully. It could change its language, increase the sense of concern. Quite possibly, it could drop that famous word "measured" which I certainly wouldn't miss.
What's your view on the economy?
The economy has slowed. GDP growth last year was 4%, it's slowed to 3%, maybe because of higher energy prices. There are very few other factors leaving an accelerated long downturn in question. Autos are an exception, but broadly across industries inventory build-up is not a problem. Employment is growing. Consumer confidence is not at levels preceding a deceleration. Data for March and April was distorted because of Easter and was weaker than trends warranted. April data will probably show some rebound. We may need to see the May/June data. It's important to distinguish between the ebb and flow of quarterly GDP rates and a longer term trend that is still very healthy. The Fed will continue to normalize rates.
How are you positioning yourself to accommodate your view on rates, the economy?
We do believe the yield curve can continue to flatten. We like longer Treasury strips, 20-25 years. They're not particularly attractive in their own right, but they're attractive relative to the front-end. Normally when the Fed tightens, the yield curve sells off and flattens. It should continue to do that. There is also the small chance that we're wrong and the Fed will stop at 3%. Then the yield curve is too steep and they're a risk reducer relative to our core short position.
Do you expect to see an inverted yield curve?
I would be surprised to see the curve invert unless we see below trend GDP rates for a couple of quarters. All yields probably will rise as the Fed pushes rates higher. Ten-year notes are between 4 1/4% and 4 1/2%, we think the 10-year is fair valued closer to 5%. We're targeting the 10-year note close to 5% this year and higher in 2006, which is consistent with a good, solid growing economy and not restrictive in a healthy economy.
What's your view on foreign buying of U.S. debt?
Foreign buying is a powerful factor. It's driven primarily by the fact that many economies are generating excess savings and because our markets are the most broad and liquid, their savings flow here. It's a factor limiting the rise of interest rates but only limiting it to a point. It's keeping yields lower and the curve flatter than otherwise, but it can't really interfere with the Fed lifting the whole curve from the front.
It's demand that is not going away anytime soon. But eventually the flow will slow, probably when they find better investment opportunities in their own countries. And interest rates will rise because of competition from foreign economies over time. As financial systems improve, that will force our interest rates to rise to compete. It's difficult to know if that starts this year, or long-term where that's headed, but it's another reason to be cautious.
Do you use TIPS in your portfolio?
We use TIPS tactically. Right now we have a fairly limited amount. The bond market prices three things: real rates, inflation and term premiums. And TIPS focus on the real part because they don't have inflation risk and the richest part right now is the real interest rate part. Inflation and term premiums seem fair. So relative to nominal bonds, TIPS are focusing on the most expensive part of those three elements and we think you can do better than 1-1 1/2% real interest. If not, investors really should give up.
What other economic trends are you focusing on?
One other factor that is a long-term negative is fiscal policy. The budget deficit is not huge but it's large. In the long run, there's a chronic problem of rising budget deficits. It's difficult to imagine much action by the government when it can fund it at such low interest rates. The budget deficit can stay large until the capital markets say no. In a sense there's a need for some capital market pushback before the budget deficit slows. At some point rising rates will be part of the mechanism that compels the government to reduce its budget deficit.