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Investors reap spoils of deflation war
The Fed's decision to fend off a disastrous spiral with continued low interest rates virtually guarantees high bond prices, and down the line, higher stock prices, too.
By Timothy Middleton
Ive been telling you for months that your Treasury bond funds were getting risky. Ignore me: Ive been trumped by Alan Greenspan.
Last week, the Federal Reserve announced it would do virtually anything to forestall the possibility of deflation. And the very first thing it did was to hold down short-term interest rates while starting to bring down long-term rates.
The Fed is signaling short rates will remain on the low side indefinitely, says John Lonski, chief economist of Moodys Investor Service. The immediate effect is to virtually guarantee high bond prices for the foreseeable future and to imply further capital gains, as well.
What's more, the Fed is extending its reach to longer-term interest rates from short, buying two- to five-year Treasury notes to drive down their yields. Among other things, that makes financing capital spending and creating jobs easier.
Bonds win in the short term
This is a peculiar role for a central bank because, if successful -- and the Fed has an almost unlimited ability to impose its will on the financial sector -- it generates inflation. But that fear is receding; the Fed expressly said it fears falling prices more than rising ones.
Deflation hasnt bothered the United States since the Great Depression, so most Americans dont appreciate how terrible it can be. When prices are steadily declining, individuals and corporations put off buying. Corporate profits disappear, crashing the stock market, and so do jobs, crashing the economy. Banks fail when their loans and mortgages go sour.
Ultimately, then, the Feds action will benefit stockholders more than bondholders. This could be the last hurrah of the great big bull run of U.S. fixed income, says Jack Malvey, Lehman Brothers global fixed-income strategist.
But in the meantime, investors who've been shoveling record sums into bond mutual funds will be rewarded. The winner is the long end of the bond market, particularly the investment-grade (corporate) area, Treasurys and municipals, says John Miller, manager of Nuveen High-Yield Municipal Bond Fund (NHMAX).
That fund stands to be a less immediate winner because the Feds policy goal is to support prosperity. That goal, which benefits corporations and their employees the most, was enunciated last fall by Fed Governor Ben Bernanke.
In a speech, he vowed the central bank wouldn't tolerate price deflation, which has been ravaging Japans economy for a decade. Paul McCulley, chief Fed watcher for Pimco Funds, the nations premier fixed-income investor, promptly dubbed his tack the Bernanke Put.
That is, Bernanke was implicitly putting a ceiling on corporate borrowing costs, thereby providing stability to the private sector as it struggled to rebuild through capital spending. Corporate bonds began to rally immediately, and they rallied further when Greenspan put his imprimatur on the put in the form of last weeks announcement.
The direct and indirect approaches
That same put naturally benefits Treasury bonds, because they're the only kind the Fed can buy directly. It can influence corporate yields, but only indirectly, by pushing down rates in general and by making loans to banks that they can collateralize with corporate debt.
By explicitly raising the fear of deflation, the Fed last week monetized Bernankes Put, meaning borrowers dont have to worry about higher rates and indeed might enjoy lower ones.
Bonds immediately rallied. In the trading week that ended May 8, Pimco Total Return (PTTAX), the nations largest bond fund, spurted 0.61%, which in bond terms is as racy as a NASCAR lap. The fund is ahead 3.83% so far this year.
In cahoots
At the same time, the Feds new tactics are sounding alarms among some fixed-income managers and reviving memories of Operation Twist, the last time the Fed and the Treasury Department worked so openly together to manipulate long-term interest rates.
Youve got the Fed and the Treasury in cahoots, says Jim Cusser, a bond manager with Waddell & Reed. Theyre trying to flatten the yield curve so Ford Motor (F, news, msgs) can have less-than-zero-percent financing.
Flatting the yield curve is bond-market jargon for implementing similar interest rates for long and short debt.
In this case, whats good for Ford is good for America: growth. And its also good for George W. Bush, because when the Fed buys Treasury notes and bonds, it's funding the deficit. Monetary and fiscal policies are working jointly toward a growth agenda.
This is a nettlesome area, and it doesnt necessarily work. Operation Twist was an effort during the administration of John F. Kennedy to coordinate activity between the Treasury and the Fed, with the goal of bringing down long rates to bolster the economy while pushing up short rates to support the dollar (thus the twist). It had limited success.
My fellow columnist Bill Fleckenstein has written about Operation Twist and his own skepticism of the Feds strategy. See Earth to regulators: Let capitalism correct itself and Fantasy, the Fed and the falling dollar: Oh my!
Stocks come out on top
Still, investors in Treasury bonds can enjoy the ride. They weren't going to get it from short-term interest rates. With short rates already so low that money-market funds are yielding less than 1%, this policy lever is reaching the end of its range.
But the Fed isnt out of ammo, says Roger Early, head of fixed income for Turner Investment Partners. What theyre saying is, they have other solutions, like buying government securities at the longer end.
Buying down long rates is a whole new policy option. The Feds checkbook is bottomless; if it wanted to buy every single Treasury bond in existence, it could. All the cash it spent doing so would quickly find its way into corporate coffers and worker pay envelopes.
This is very stimulative to the economy, says George Strickland, manager of
Thornburg Limited-Term Municipal Fund National Portfolio (LTMFX). Beneficiaries would also include state and local bonds, as general credit quality improved.
So while holders of Treasury bonds are toasting each other today, the booze should be flowing more freely at stock mutual funds, as well. Fiscal and monetary policies are working in tandem to create a stronger economy, which President Bush will need if he is to be re-elected.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article. He is writing a book about Bill Gross, manager of Pimco Total Return Fund, for John Wiley & Sons.
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