Thursday, February 22, 2007

CPI and Bonds

Strategists in the Global Fixed Income Research Division of UBS comment that, "Fed officials (Poole and Yellen) used yesterday's slightly higher than expected Core CPI print to remind the investing public how pleased they are to have maintained their tightening bias in the face of a housing recession. We think that the drag from . . . housing will ultimately translate into weaker US employment conditions -- spurring a series of rate cuts that will begin in May. For the near term, however, the Fed has the upper hand which means that rangebound conditions in bonds are likely to persist for a while longer. Sadly."

We suspect that yesterday's news of additional subprime lending problems, this time at Novastar Financial, emboldens strategists to predict a near-term rate cut. We doubt it will occur this soon unless the mortgage market really begins to unravel. While that is possible (see today's WSJ article on C1 that reports that as of the third quarter 2006 there were $1.28 trillion in subprime mortgages outstanding, which represents about 13% of the $10.0 trillion mortgage market), we believe global liquidity will delay rate cuts til later in the year. However, we continue to believe that longer-term rates will continue to dial down in a slow fashion. Contrary to UBS, we are "saddened" by lower long-term rates because it makes it that much more difficult for retirees and investors to capture an adequate cash flow on investments. We would much prefer a gradually rising rate environment that permits more attractive reinvestment options even if it means slightly less-than-coupon total return to get the higher rates. We just don't see that happening. As such, we find it increasingly important to have value-added solutions such as our Dynamic Fx Strategy. This strategy overlays a long or short US dollar bet on a generally intermediate-term bond portfolio. The chart on the right shows the favorable performance relative to the Lehman Aggregate Bond Index (as usual, past performance is no guarantee of future performance). See our website for more information on managed accounts.


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