2007...Part 3 -- Interest Rates & Bond Market

Short Term Rates

Well, it is a 5.25% market at the short end. My super
long term short rate model pegs the Fed Funds Rate at
about 4.25%. The current FFR 100 basis point premium
reflects both the recent rapid deceleration of inflation
coupled with fundamentals which support a continuation
of a 5.25% FFR, recognizing that said fundamentals do
now tilt slightly toward ease. I continue to expect the
Fed to hold at 5.25% with a bias toward tightening if the
economy holds up as I anticipate. For the short run, we
still have to see how much of an inventory adjustment will
take place in the wake of the slowing of the economy.

Short rates at 5.25% offer a positive after tax, inflation
adjusted return. There is now no economic compulsion to
spend or invest money. Maintaining a positive offering to
savers is important if the US is to regain better balance
between savings and spending, as it keeps the internal value
of the dollar stable. I suspect this is a secondary objective
of the Fed.

As mentioned in the previous post on monetary policy, I think
the Fed wants to avoid easing for as long as it can. However,
I plan to follow the financial market fundamentals closely and
will point out changes as they occur.

Bond Market

I have paid scant attention to the bond market over the past
eighteen months. By my lights, the market has been overvalued,
and not worth the time. I have missed a couple of good trades
but trades in equities more than made up for it.

The long Treasury at 4.70% provides a modest premium over
inflation of 2.0-2.5%. So, the market is ok to trade now, but
investors need a solid 300 basis points minimum over the CPI to
warrant long term positions given the uncertainties of interest rate
risk in the long run. You can earn 5.25% now nearly risk free,
so why saddle yourself with pre-maturity risk to principal that
comes with extending out? One can sing a different tune if the
economy is headed for a lengthy period of price stability or
some deflationary pressure, but that is not the view I support.

The bond market has proven to be most sensitive to the momentum
of industrial production and industrial commodities prices. I
use a combined measure computed on a six month annualized rate
of change basis. This measure had readings of +10 - 12% over the
first half of 2006, but has tailed off to a 2.7% annual rate over
the second half of the year -- hence the strong rally in the bond
market since May. Since my best guess is that this measure will
strengthen significantly later in 2007 and especially in 2008, I
would expect bond yields to trend up certainly by the third
quarter of next year if not sooner.

The powerful rally in high yield or junk bonds over the past six to
seven months coupled with an ongoing small spread between top quality
and intermediate corporates suggests the bond market is not concerned
about recession, inverted Treasury yield curve notwithstanding.
Rather, it appears there is considerable speculation that the US
economy is losing its inflationary bias in the intermediate term.