Fixed Income: 2009 Year-End Summary

Includes: KBE, TBT, XLF
by: Bernard Thomas

2009 is winding down, but the year will not go quietly. First there was the Dubai default. Then there were the Greece and Spain credit ratings downgrades. Even the U.S. and UK received stern warnings about their respective credit ratings coming under pressure in the near future. The grass isn't greener in the neighbors' back yard. In fact, even China, that vaunted engine of growth, is not is nearly as strong as its economic data and its cheerleaders would have us believe. Nearly all of its growth has been driven by huge amounts if government stimulus, which is sustainable. What the Chinese government is hoping for is that it can keep its economy expanding (and its people happy) until demand increases from (drum roll, please) the U.S.!!! The good ole USA is still the world's main source of economic activity.

There is a mistaken belief that U.S. banks are the worst on the planet. Although U.S. banks (even healthy banks) remain impaired when compared to their typical condition, European banks (along with others in various parts of the world) have their fair share of impairment and foreign governments are feeling the pain of propping them up. It may be fair to say that the worst of the financial crisis is over, but it may be a long time (if ever) before we return to conditions common during the past 25 years.

Why if ever? Let's answer a question with a question. Why do many people assume that the economic conditions of the past 25 years are "normal" After all, those conditions never existed prior to that time period. The truth is that there is no "normal" The economy is evolving and ever-changing. One thing is for sure. Consumers cannot spend more than they make ad infinitum. Eventually one becomes over leveraged and can no longer spend like a drunken sailor.

When that happens, demand falls and prices follow. All of the government spending or shovel-ready jobs the government can conjure up can create sustainable economic expansion similar to what we saw during the days of ever-cheaper and ever-easier credit.

So what does this mean for the markets? As it becomes apparent that the U.S. remains the best of a fermenting (I won't say rotten) bunch, the dollar will strengthen. Equity markets will begin to trade sideways (possibly correcting mildly), non-industrial commodities will fall (see gold) and the dollar will strengthen. At some point, the Fed tightens further strengthening the dollar. Tighter money takes away the bank carry trade and makes leverage more expensive which in turn makes borrowing to play the markets more expensive.

The result will be credit spreads stop compressing and corporate bond yields begin to follow movements of treasury yields. The reason is that bank profits will moderate from levels seen in 2009. Most other sectors of the markets will see spreads remain constant or widen slightly. Junk bonds could see a significant correction in a year or two as weaker firms struggle to refinance debt at affordable levels (if at all).

I think Fed Chairman Ben Bernanke has it right when he says that the economy will grow, but will face significant headwinds. Investors will have to accept that they are in fact investors and not traders because trading opportunities will be fewer and farther between than to what they have become accustomed.

Ladders and barbells, anyone?

Disclosure: Author holds a long position in TBT