Columbus sailed the seas long ago to prove the world is not flat, but today many short-term fixed income investors could be forgiven for thinking otherwise when they look at the shape of the yield curve: Whichever way they turn, they run the risk of sailing off its flat edge.
For the past 30 years, duration has been a formidable wind filling the sails of all fixed-income investors, including those with shorter investment horizons. However, these tailwinds of duration are gradually turning into headwinds. With quantitative easing (QE) pushing front-end rates toward even lower yields than market participants thought was possible, investors are indeed navigating unfamiliar waters.
The encouraging news is that the marketplace already appears to be changing, as expectations of Federal Reserve hikes begin to coalesce on the horizon. While consistently cautious about looking into the future, PIMCO does not believe that we are about to sail off the edge of the investment universe. There are other oceans to explore for short-term investors, which requires looking less at duration and focusing more on "safe spread," or those securities or investments most likely to withstand the vicissitudes of a wide range of possible economic scenarios, and can consequently be a source of potential outperformance in this new environment. Our goal is to help investors identify the dynamic and potentially profitable opportunities which may emerge.
Warm Trade WindsA variety of signs point to improving economic conditions, including a decline in unemployment and relatively contained inflation. Yet the foundation of the credit system continues to be in a fragile state, as financial institutions around the world remain in defensive mode, preserving liquidity instead of fully resuming their core business of making loans and extending credit. The U.S. financial system is a case in point, as credit extended for real estate and consumer loans is at historically low levels. This is also true of commercial and industrial loan formation; which, although it recently found a bottom, shows tentative footing at best.
Until the Federal Open Market Committee (FOMC) is convinced that credit creation and the money multiplier are back in full force, that employment has stabilized, and inflation is an imminent threat (as specified under the central bank's dual mandate,) it will likely remain on the sidelines. This will likely chart a course for static Fed policy into the first part of 2012 and possibly beyond, as the economy tries to regain its footing. With this map in mind, we can use duration as a limited tool, realizing its ultimate fate is a dwindling source of alpha, but nonetheless implementing it with proper positioning on the curve to enhance return potential. Current technicals appear to favor this approach, with the upcoming debt ceiling debate and the recent retirement of the Treasury Supplementary Financing Program (SFP) likely to drive front-end rates lower.
Still, front-end investors need to be mindful of not only the secular dynamics in play, but the cyclical ones, too. While the duration headwind could become a formidable force, it currently has the strength and feel of a warm summer's breeze. A persistent output gap, the dearth of corporate R&D investment, and relatively contained core inflation figures provide a reasonable buffer against any immediate potential for FOMC tightenings.
Calm or Stormy Seas?Despite our optimism, we remain mindful of the fact that the seas of tranquility for short-term investors who cherish liquidity can quickly become choppy. In the U.S. and European markets, investors often rush for the exit at early signs of trouble, only to be lured back by the force of the (presumably U.S. dollar) liquidity that is demanded by European participants. As we observed in 2008 and again in 2010, these cross currents of liquidity do not operate independently. Since the beginning of 2011, we have seen U.S. money market funds re-emerge to fund European financial institutions via commercial paper purchases.
While balances have declined over the past few months, investors should remember this connectivity between the U.S. liquidity situation (for money funds) and the European Financial system. As the European Central Bank (ECB) continues in its attempts to formally drain liquidity from the European theatre by allowing the fixed rate "all-you-can-eat" longer-term refinancing operations (LTROs) to expire in favor of floating rate market clearing mechanisms, European banks will become more reliant on their relationship with U.S. investors.
On the other hand, the constant search for attractive yield from U.S. SEC Rule 2(a)-7 money-market funds within their stringent parameters only creates a situation which acts as a siren for those confined investors. We continue to feel that remaining within the strict confines of money market territory is equivalent to trying to win the America's Cup with a ten-foot dinghy. Money market investors are simply going to be out-powered in terms of maneuverability.
Update Your MapsHere are a few of the strategies worth considering in the search for an attractive spread while maintaining a short maturity horizon.
Broader Investment HorizonsJust as Christopher Columbus used unconventional thinking to venture out and discover new worlds, short-term investors should keep an open mind when evaluating opportunities in the new investing environment. To be sure, venturing out beyond our comfort zones always presents risks (including the risk that the landscape could shift in new, unanticipated ways) as well as potential rewards. Our approach is to explore judiciously.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio.
Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011, PIMCO.
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