BondsOnline Advisor
November 2005
by Stephen Taub

Time to Go Long(er)?

Wall Street’s strategists are signaling their next strategy move as the Federal Reserve gears up for a likely 25-point hike in the Fed Funds rate on December 13.

Most pros agree that the Fed will stop raising short-term rates once they hit 4.50 percent--or certainly when they top 4.75 percent—from the current 4 percent.

So, Wall Street’s pros are positioning themselves to take advantage of the subsequent opportunities and are recommending that investors start to consider moving out to longer maturities.

For example, Lehman Brothers said in its most recent weekly report to clients that it believes the world bond market will remain in a bearish mode until the end of this central bank tightening cycle becomes more clearly defined. It added that sometime between the middle of the first quarter and the end of the second quarter of 2006, “the all-clear” may be able to be sounded for bond markets.

 “Already though, we are getting excited about the prospect of being able to suggest a major change in debt portfolio policy in 2006,” it stated. “In particular, we look forward to being on the long side of duration for extended stretches of 2006.”

Smith Barney is more eager to move further out onto the yield curve. It recently told clients that the sheer volatility in and of itself may be the early signs of an "endgame" for Fed tightening and the rebound in long-term rates. “In other words, we think that "buy on weakness" as a strategy should trump "don't fight the tape," Smith Barney’s municipal bond team recently told clients.

In general, the investment bank acknowledges that there is more volatility in the bond markets, due to a number of reasons.

Investors have had trouble figuring out the ramifications of Hurricane Katrina. First, energy prices soaring and economic data was subsequently soft. Were these two developments related? Was Katrina causing inflation to rise—which puts pressure on rates—or weakening the economy, which eases pressure on rates?

“It remains difficult to tell just how much of the recent softer economic data, including the employment numbers, result from Katrina-induced problems or from the subsequent spike in energy prices,” Smith Barney stated. “In addition, the sharp weakening in energy-sensitive sectors such as autos is making the consumer data difficult to interpret.”

It notes that fourth quarter consumer spending growth could be as low as 1% when auto sales are included, but a far more robust 3% without autos. “Which reflects ‘real’ trends in consumer spending?” it said. “It is difficult to tell.”

Smith Barney also noted that the inflation data is hard to discern. How much should investors weight fuel and food? How important is the nascent rise in long-term inflation expectations, which recently moved above the 2.6% to 2.9% band that had prevailed for more than five years, the investment bank asks. “And how difficult will it be for the Fed to ensure that this change does not become structural,” it added.
 
Even trading patterns within the Treasury market itself are contributing to heightened volatility, Smith Barney pointed out. It added that much of the recent selling in Treasuries appears related to hedging activity by mortgage originators and services, rather than to a broader profile of bond market investors.
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In the broader market, short positions appear to have increased sharply in Treasury futures, it noted. “This is a pattern that could actually provide additional support if rates were to recede,” it added.

 “Once the tightening ends, the impetus toward higher long-term rates is also likely to recede, and ultimately be replaced by somewhat lower rates,” the investment bank added. “Indeed, given current concerns around inflation and inflation expectations, it probably makes sense for the Fed to ‘overshoot’ a neutral stance to some degree, rather than risk ending its tightening phase too early. If that turns out to be the case, the last few rounds of tightening could be reversed fairly quickly in 2006 or in 2007.”

The upshot: Smith Barney recommended continuing to ease into the bond markets and lengthen maturities over time. “Attempts by individual investors — and many professionals — to time the precise peak in interest rates are likely to prove futile,” it adds. “And once long-term rates do reach a peak and begin to recede, the first downward move could be fairly precipitous, as investors who missed the peak attempt to get in before rates decline too dramatically.”

Not everyone agrees, however. UBS just came out with a report that recommends investors underweight duration because it expects Treasury yields will drift higher over the balance of the year. It notes that although the yield on the 10-year Treasury note has climbed 55 basis points over the last two months, it is still below fair value.

Based on UBS economist estimates for growth and inflation, the investment bank said it estimates the fair value yield of the 10-year Treasury note at 4.75% to 5.0%.

“The Fed's well-publicized inflation concerns will likely keep the Fed in a tightening mode through January-and keep upward pressure on Treasury bond yields,” it added. “Given our interest rate call for higher bond yields, we see little value in the long end of the yield curve at this point and believe extension trades do not compensate investors for the incremental interest rate risk. The expected return per unit of risk is currently much higher in the short end than it was in the summer of 2003, when the curve was at a cyclical wide. Consequently, we recommend investors reduce exposure to longer maturity bonds for a comparatively modest yield give up.”