Recent feedback from the field indicates that higher interest rate fears are more prevalent among financial advisers and their clients than among fixed income professionals. Are these fears being stoked by wholesalers, newsletter authors or equity strategists? From what we have been told it is all of the above. There are very few fixed income pros calling for skyrocketing long-term interest rates and corresponding soaring inflation. Forecast data compiled from Bloomberg News bears this out.
Bloomberg News compiles forecasts for interest rates on various spots on the curve from economists around the industry. The consensus opinion places the 10-year U.S. Treasury note yield in the area of 3.53% in the fourth quarter of 2011 based on the Bloomberg Weighted Average. The Q4 2011 median forecast is 3.51% as of this morning. Looking out into 2012 shows a weighted average 10-year U.S. Treasury note forecast of 3.83% and a median forecast of 3.80% (however, fewer economists submitted forecasts for Q1 2012). Even Morgan Stanley (MS), whose fixed income marketing desk has been suggesting floaters for higher interest rates (along with other bad, dangerous or misinformed strategies), forecasts a 3.75% 10-year note for Q4 2011. With few exceptions, the fixed income side of the business is not forecasting soaring long-term rates. Maybe I am biased, but I believe economists have a better handle on where rates are probably going than fund wholesalers and equity market participants.
What about the yield curve? Isn’t the yield curve forecasting strong growth, a booming stock market and higher inflation? The yield curve tells much, but predicts little. By that we mean that it reflects monetary policy on the short end and its expected effectiveness and inflation expectations on the long end. The yield curve reflects more than it predicts. One pundit was on CNBC this morning stating that the yield curve was predicting strong growth and a strong stock market. We thought that a Fed Funds rate, which is effectively 0.00%, and two rounds of quantitative easing were responsible for such expectations and the yield curve was a reflection of policies and expectations. The pundit defended his position by stating that the inverted yield curve seen just prior to the last recession was forecasting an economic downturn.
Excuse me for being so bold, but what would one expect after several years Fed tightening? Again, the yield curve was reflecting market sentiment based on monetary policy and expected results. If the yield curve was to be looked to as a predictor of the last recession one could argue that it underestimated the magnitude and severity of the downturn. However, if one accepts that fact that the yield curve is merely a reflection of market sentiment based on policy decisions and inflation expectations then the yield curve is useful as an economic barometer.
I am not a mutual fund expert. My focus is on individual bonds and custom-tailored portfolios. However, this is not to say that I do not pay attention to what is being said in the fixed income mutual fund business. The CEO of Thornburg Investment Management Inc. was on CNBC discussing his firm. He was asked how his fixed income funds have been able to perform well through a variety of economic and market conditions. His response was that Thornburg ladders maturities, diversifies and does not try to predict interest rates (time the market). We could not agree more. In our opinion, laddering is the best way to invest for income in the fixed income markets. Swapping should be kept to a minimum and probably should only be used to rebalance accounts to meet client goals, objectives and risk tolerances.
In closing we would like to address market inefficiencies. In today’s market the desire for yield is strong. There are few if any inefficiencies in which bonds are priced below their true values. If anything, many bonds are inordinately rich. If a bond looks exceptionally attractive for its credit rating ask a professional why this is so. Chances are that there is a negative story associated with that bond. Also, consider the source of the information or investment idea before acting.