Which Way are Rates Headed? March 23, 2012, Managing Director and Portfolio Manager
The bond market has had a rough first quarter in 2012. More specifically, U.S. Treasuries rose rapidly in yield (declining prices) as a number of events unfolded to reduce the demand for safe haven investments. Economic activity in the U.S. appeared to be better than forecast, as a mild winter permitted the construction industry to work instead of shutting down as is normally the case. The mild winter may also have contributed to better than expected employment numbers. Non-farm payrolls showed a significant pick-up in private sector hiring, which is certainly a positive after several years of subpar activity. As of today, five-year Treasuries are roughly 40 basis points higher in yield than at the end of January, when yields hit their lows. The benchmark ten-year Treasury has risen approximately 55 basis points from the low yields, while the thirty-year Treasury is currently 50 basis points higher in yield.
As a separate account bond manager, we try to always be forward-looking, anticipating moves in market extremes as well as moves in the economy. There are a few issues that we are focusing on that have implications for the economy and interest rates specifically.
Energy Prices
While crude oil prices are up about 5% year-to-date, gasoline prices have risen over 18%. Gasoline is the most widely used commodity in the U.S. and certainly the most visible. Who does not drive past a gas station without noticing the price at the pump? We know that every one-cent increase/decrease in the price of gasoline impacts consumer spending in the U.S. to the tune of $1.4 billion dollars. Given a national average price of $3.92, this would equate to an $80-90 billion tax on the consumer (less money for consumption of goods and services). To complicate the picture further, the Department of Energy reported that gasoline demand is down a whopping 7% from a year ago. This makes no sense and may be an error in measurement by the Energy Information Agency (EIA). The Wall Street Journal reported that the U.S. has significantly increased exports of gasoline and this may not have been counted in the EIA’s calculations. In sum, energy prices have an upward bias and this should affect spending on other goods and services serving to dampen economic activity.
European Debt Problem
While the Greek tragedy has moved off center stage, problems still lurk for several countries in the Euro area. Portuguese ten-year bonds are currently trading in the 12-13% range, eerily similar to where Greek debt was trading about one year ago. Spanish government debt yields have started to rise, as the euphoria of the Greek debt exchange fades. Credit default swaps (CDS) on Portuguese government debt have tripled in price since 2011 from a low of 400 to over 1200. Spanish CDS premiums have just about doubled to over 400. These measures of health (read illness) suggest these patients have some serious issues to address. Spain has an unemployment rate in excess of 22% and Portugal’s unemployment rate is just under 15%. Clearly these countries have structural problems and an inability to grow their economies in rapid fashion to deal with them. The Eurozone is experiencing another recession as a result of the problems in “Club Med.” A parallel to keep in mind was in 2007 and 2008, when it appeared the financial crisis was averted and “contained” with the shotgun marriages of Countrywide with Bank of America, and Bear Stearns with JP Morgan Chase. No one was willing or able to go to the altar with Lehman Brothers.
U.S. Fiscal Policy
U.S. fiscal policy has been non-existent since the 2009 stimulus package that concluded last year. Only temporary measures have passed a divided Congress, reducing their impact, and some laws are set to expire at the end of this year. The Bush tax cuts are also scheduled to sunset at the end of this year, effectively raising taxes. Several other measures will need to be reauthorized to keep tax rates and tax incentives at current levels. The call for fiscal austerity seems fairly strong at the federal level as well as in state capitols.
Outlook With these potentially significant headwinds (energy prices, Europe, US fiscal policy) Cumberland continues to maintain a longer-than-benchmark duration on our taxable fixed income accounts. Economic activity should remain positive but well below potential. Our addition of TIPS (Treasury Inflation Protection Securities) to keep pace with a rising CPI and anchor the short end of a barbell strategy remains in place. We continue to add longer term taxable municipal bonds to take advantage of their higher yields when compared with investment grade corporate bonds.
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