August 2012

The heightened volatility in the fixed income market that first developed in mid-July continued into August, as investor continued to grapple with mixed economic signals and nervousness out of the Federal Reserve. The 30-year Treasury bond began the month with a yield-to-maturity of 2.54%, which rose to 2.95% mid-month before falling back to 2.67% at month end. That equates to a more than six percent price loss and a subsequent recovery of nearly five percent. The broad market, as measured by the Barclays Aggregate Bond Index, experienced similar volatility, with the index losing as much as 1.08% mid-month before closing the period with a gain of 7 basis points.

The Federal Reserve, at the conclusion of the September Federal Open Market Committee (FOMC) meeting, announced that they will begin a third round of quantitative easing. Specifically, they plan to buy $40 billion of mortgage backed securities in the secondary market every month. That’s in addition to the $40 billion of long maturity Treasury notes they are already buying in their operation twist program. Unlike earlier rounds of QE, the Fed did not offer an end point for the money printing exercise. That point was amplified by the statement that “the committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable length of time after the economic recovery strengthens.” As if the implications of open ended quantitative easing weren’t clear enough, Bernanke, in the press conference that followed, stated that the bond buying would continue until the economy improved “substantially.” The capital markets reacted to the message with a sharp drop in bond prices and an equally sharp rally in equity prices. In the twenty four hours after the announcement, the S&P 500 was approximately 2% higher and the 30-year Treasury bond approximately 2% lower in price. Historically, the Fed begins to reduce accommodation as economic growth accelerates and inflationary forces increase. The quick and dirty interpretation of Bernanke’s statement is that the monetary accommodation will continue even as inflation exceeds the stated target. With that acceptance of higher inflation, the already negative real rate of return on 10-year notes will become even more negative, resulting in reduced purchasing power when those notes mature. Conversely, tolerance of rising inflation means that nominal profit forecasts should be raised, which effectively lowers forward price/earnings expectations, hence the rally in the stock market. However, equity investors should take care, in that price/earnings multiples typically fall in a rising inflation environment.

We caution that tolerance for a “little more” inflation runs the risk of a rising inflation expectations spiral. Such a spiral works as follows. Consumers react to prices rising faster than expected by demanding a wage increase that is at least in line with the greater than expected price rise. As prices continue to rise at a faster rate than consumers expect, they continue to demand a wage that will keep them in line with rising prices, but will also demand an increment above that rate for assuming the risk that inflation will again register more than their last wage adjustment. In saying that monetary policy will remain accommodative as inflation rises implies that the Fed can break such a feedback loop. With such an enormous amount of liquidity already in the system and an enormous amount on the way, we’re concerned that the Fed will not be able to normalize policy without damaging the economy.

However, inflation is unlikely to spiral out of control or anything close to such an outcome in the near future. Our expectation is that the recent selloff will bottom as the Fed rolls the printing presses and buys paper in the open market. Also, economic uncertainty caused by the looming fiscal cliff is likely to keep a lid on economic activity. If anything, campaign “mud-slinging” may suppress consumer confidence and with it, fourth quarter retail sales. Despite that fear, we continue to remain defensive and seek to minimize our sensitivity to interest rates.