Fixed Income Strategist - January 13
Range-Bound Yields in 2006
* Outlook: Approaching the end of the tightening cycle:
The cumulative 325 bps rise in the fed funds rate since June 2004 has
moved monetary policy from an accommodative posture closer to a
neutral stance that neither restrains nor promotes economic growth and
indicates that the tightening cycle is drawing to a close.
* Duration: A neutral outlook:
Against an anticipated backdrop above trend growth, a modest
acceleration in inflation, and additional Fed tightening, we expect
Treasury yields will be biased slightly higher this quarter. As a
result, we are maintaining a neutral duration weighting of 97.5% of
benchmark.
* Yield Curve: Favor short to intermediate maturities:
Given the flatness of the yield curve, short to intermediate
maturities offer investors a better risk-adjusted return potential
than longer maturities. Consequently, we recommend investors ladder
their fixed income holdings between the 2- and 10-year portions of the
maturity spectrum in the taxable bond market. In the municipal market,
we like the 10 to 15 year range.
* Sectors: Maintain sector weights:
We recommend a modest overweight of mortgages, municipals, and TIPS;
market weight Treasury and agencies; and underweight credit.
* Sector Allocations
Short and long term bond yields followed distinctly different paths in 2005, with the yield on the 2-year Treasury note climbing 133 bps but the yield on the 10-year Treasury note rising a much more modest 13 bps. The steady upward drift in short-term bond yields resulted from measured tightening by the Federal Reserve, which lifted the target fed funds rate to 4.25% from 2.25% in eight consecutive 25 bps increments. The rise in Treasury yields eroded the principal component of total return; however, all core fixed income sectors in our coverage universe still posted positive returns. Total returns ranged from 2.80% for the Treasury market, the best performing sector, to 1.95% for the investment grade corporate sector, which had the poorest performance.
Our economics team looks for one more 25 bps rate increase in the fed funds rate, at the January 31 FOMC meeting, and expects the Federal Reserve will hold the funds rate steady at 4.50% for most of the year. Following two consecutive years of above average growth, real GDP is poised to slow to the 3.0% area, the US economy's long-term average. The cumulative 325 bps rise in the fed funds rate since June 2004 has moved monetary policy from an accommodative posture closer to a neutral stance that neither restrains nor promotes economic growth and indicates that the tightening cycle is drawing to a close.
We look for Treasury yields to be range bound in 2006, with the 10-year Treasury yield fluctuating between the 4.25% to 4.75% area. Stronger growth and rising inflation pressures in the first part of the year, along with additional Fed tightening, should bias Treasury yields modestly higher this quarter. In addition, issuance in the Treasury, agency, and corporate bond markets is expected to be heavy. Municipal bond issuance may also be strong. As a result, we believe the 10-year note yield may touch the 4.75% area this quarter. However, as growth cools in the second half of the year, inflation stabilizes, and the Fed holds the fed funds rate steady, we expect Treasury yields to trend somewhat lower.
In contrast to short-term bond yields, which closely track the fed funds rate, longer-term bond yields are highly sensitive to inflation expectations. Because of confidence in the Fed's ability to contain inflation, investors' inflation expectations may be lower than in the past. As a result, the credibility of the Federal Reserve itself may have tempered the rise in longer-term Treasury yields last year. In addition, other structural factors have helped to dampen longer-term Treasury yields-and these factors are likely to remain in place in the coming months. The glut of global savings and strong demand from international investors likely blunted the impact of tighter monetary policy on longer-term bond yields. The average maturity of Treasury debt has fallen rapidly, from over 9 years as recently as 2002 to just over 6.5 years in 2005.
Against an anticipated backdrop of above trend growth this quarter, a modest acceleration in inflation, and one or two additional Fed rate hikes, we expect Treasury yields will be biased slightly higher this quarter. As a result, we are maintaining a neutral duration weighting of 97.5% of benchmark. Given the flatness of the yield curve, short to intermediate maturity bonds offer investors a better risk-adjusted return potential than longer maturities, in our opinion. Consequently, we recommend investors ladder their fixed income holdings between the 2- and 10-year portions of the maturity spectrum in the taxable bond market. In the municipal bond market, we like the 10- to 15-year maturity range, where 90% of the full curve yield is available. By the end of the year, we expect municipal bond yields to be lower than where they are today; thus less defensive bond structures are likely a better idea at present.
We have a somewhat negative view of the credit markets and recommend investors underweight corporate and preferred securities. Although spreads widened in 2005, a trend we expect to continue this year, they are still tight from an historical perspective. Bullet spreads, particularly in the front end of the agency curve could come under additional widening pressure in the first quarter on an uptick in supply. However, for investors who are seeking a stable source of income, rather than the potential for short-term total return, the widening in agency bullet spreads makes them attractive from a tactical standpoint. With our perfect current coupon model valuing mortgages as "cheap" and supply/demand technicals likely to be balanced in 2006, we maintain our modest overweight in mortgages. Likewise, we maintain a modest overweight on TIPS, given low breakeven spreads.
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