Expected Inflation

We've recently had considerable hand-wringing in the press regarding inflation expectations. One of the best measures of inflation expectations is the spread between the 10-year T-note yield and the 10-year Tips yield. While both indexes have risen since the beginning of the year, the spread has actually declined from previous highs: last week the spread was 2.59% versus prior peaks in second quarter of 2005 and mid-2004 of around 2.8%. It has also declined from the 2.72% level of a month ago.

With real estate dramatically slowing, consumer spending coming in under expectations and inventories rising we think inflation will not be a concern.

Strategy Update: We continue to be slightly long the US dollar in the Dynamic Fx Strategy. Our initial entry on the long side of the dollar was due to the extreme consensus of sentiment that one should be short the dollar, in addition to some fundamental reasons to expect a pause in the weakening. We continue to believe that a short dollar position is inevitable over the next several years - hence, the only small exposure to the long side. This strategy is designed to provide intermediate bond yields enhanced by exposure to either long the dollar or short the dollar using the US Dollar index.

Industrial Production

The drop in industrial production has been weaker than expected with most consumer durables experiencing cutbacks. This has been particularly true in the auto segment but also extends to building materials, furniture and appliances. Overall retail sales have been weak and we suspect there has been some undesired build in inventory.

So why are the markets worried about inflation? Some of this reflects the way the consumer inflation measures are calculated. The primary input to consumer prices is housing but it doesn't really measure housing prices. Rather, it measures owners equivalent rent. Since rent didn't keep pace with house inflation over the past 5 years the housing portion of the inflation numbers actually underestimated true inflation. Interestingly, now that we are seeing a flattening of housing prices there has been some upward pressure on rents. Some of this is due to the reduced stock of rental units as a result of condo conversions and a general rise in home ownership rates.

Ironically, we could see rents continue to increase in the face of additional slowing in the economy. People have to live somewhere - if their house is foreclosed on they may move to an apartment.

We see temporary respite in the drop in auto sales but look for a continued slowdown in consumer spending. This will likely begin to increase the savings rate, reduce the trade deficit and stall job creation. It also means true inflation is not a problem. In fact, we believe inflation momentum peaked last September. We look for intermediate to longer-term bond interest rates to begin a moderate drop later in the third quarter.

Strategy Update: Fixed income strategies continue to be longer maturity or in the process of looking for appropriate opportunities to lengthen duration.