Tuesday, February 20, 2007

Interest Rates

The recent declines in interest rates have come in spurts - note the chart on the right that shows rates declining from around 4.9% on the 10-year treasury index to just under 4.7% today. Yet it was really only 2 or 3 days that were responsible for the decline. Various commentators have complained about the lack of follow-through. Perhaps that is because they only notice rates on the bigger decline days, then the immediate follow-through seems weak. Yet it has retraced 40% of the rise off the 4.4% bottom in early December. That's not bad.

Contributing to the decline in interest rates has been a spate of recent articles on the state of the lower grade mortgage market. Increased defaults could directly affect bank loan portfolios and consumers ability or willingness to spend. But higher defaults could also jeopardize some of the speculative-grade tranches of Collaterallized Debt Obligations (CDO), which in turn could begin to impact bank earnings. In addition to mortgage loans in inventory that begin to be non-performers, many banks actually invested a significant portion of the bank's investments in CDO paper. We know of one bank that had a substantial portion of its investment portfolio in CDO's made up of loans to smaller community banks. It works while it works, but when these things stop working the wheels usually fall off in dramatic fashion. This represents a sizeable risk below the surface to the economy and bank profits. As it continues to play out we would anticipate more declines in treasury interest rates within the current trading range: 4.55% seems doable over the next few months. Corporate and mortgage credit spreads could widen under such circumstances.

Strategy Update: we continue to be long duration in our aggressive active fixed income models. Dynamic Duration Select strategy (dark line on the right chart since the peak in rates versus the Lehman Aggregate Bond Index) is hitting new highs. Visit our website for more infomation on strategies management.


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