July 25, 2005
Dow Jones Average: 10,651
S&P 500: 1,234
Interest Rate Divergence
By raising or lowering interest rates, the Federal Reserve Board attempts
to modify or reverse prevailing trends in the economy and financial
markets. While economic activity is affected by changes in interest
rates, there are other factors that can offset a modest change in
rates. Changing the behavior of investors and consumers often requires
a persistent, significant change in rates by the Federal Reserve.
Since 1998 the Fed has dramatically shifted its interest
rate policy four times. In late 1998 the Fed cut rates sharply to
prevent a possible economic recession in the wake of the Asian currency
and debt crisis. Two years later the Fed pushed rates up to nearly
eight percent with the intention of cooling off the greatest stock
market bubble in U.S. history. That policy position was quickly reversed
after the stock market collapse of 2000-2002. The Fed reduced rates
thirteen times to a sixty year low of one percent, hoping to prevent
an economic meltdown caused by malaise over stock market losses. The
extraordinarily low rates touched off a real estate boom that has
forced the Fed to once again shift course on interest rates. The nine
rate increases of a quarter point each since last summer have been
engineered to gently slow the pace of real estate price appreciation.
The steady, year long rise in short term interest
rates has had little impact so far on the real estate market. By raising
what is called the Fed Funds rate, the Federal Reserve Board immediately
affects the yield on treasury bills, short term C.D’s, the prime
lending rate at banks, and other limited duration debt instruments.
The Fed has little to no control over intermediate and long term bond
rates, which are set by the buyers and sellers of such bonds. If enough
investors are willing to accept a low rate of return on ten year treasuries,
the rate on such bonds may remain low even as short term rates climb.
For some reason rates on ten year and longer paper have fallen to
around four percent even as short term rates have moved from one percent
last summer to 3.25 percent today. The nine Fed rate hikes since summer
2004 have had virtually no impact on the real estate market, because
mortgages are based on the ten year or thirty year bond rates which
have actually moved lower since the summer of 2004.
No one seems to know why the short term and long
term rates are moving in opposite directions. Alan Greenspan has called
the divergence in interest rates a great “conundrum” that
is confusing economic policy makers around the globe. The staff of
economists employed by the Federal Reserve Board analyzed various
factors such as capital inflow from the Far East, pension funds moving
to bonds as baby boomers approach retirement, and possible fear of
economic weakness ahead. After much study they concluded that these
factors do not explain the mysterious, unprecedented divergence in
rates.
In our opinion, the Fed wants the ten year bond rate
to move up to a higher level, probably close to five percent, so that
cheap money is not so available for real estate speculation. While
the Fed can not directly set the ten year bond rate, they can keep
raising shorter term rates, and eventually that may draw investors
away from the longer term paper. The longer the Fed has to persist
with rate increases to succeed in its mission of cooling real estate
speculation and other inflationary trends, the more pressure will
build on stock market valuations.
Current Strategy
Corporate earnings are clearly benefitting from a
stronger selling environment and profit margins that are near record
levels. Strength in real estate has filtered to many sectors that
are involved directly and indirectly with home building and financing.
Despite the better results being reported by numerous companies, the
stock market has remained locked in a tight range, little changed
from its year end 2004 level. Investors are troubled by steep oil
prices and increasing interest rates. The fear is that consumer demand
may wilt in the face of higher energy bills and higher financing costs.
If the economy slows, profit margins will most likely shrink from
the current record levels.
We are continuing to selectively buy new positions
in companies that have shown resilience during periods of economic
weakness. The medical, insurance, and software sectors are the kind
of businesses that have achieved consistent growth in almost all economic
environments. While favoring such traditional growth sectors recently,
we are also maintaining positions in the more economically sensitive
stocks bought over the past two years. If the climb in oil prices
and interest rates stops, investors may have renewed enthusiasm for
the more economically driven companies. By maintaining most current
holdings, and adding new ones, we are increasing overall portfolio
exposure to stocks.
Our bond strategy is very simple. We are keeping
much of our clients’ fixed income funds in short term treasuries,
rolling these treasury bills every few months to capture the latest
interest rate increases. We are staying clear of intermediate and
longer term taxable bonds, because these bonds could lose significant
value if and when intermediate rates move to five percent. We are
buying tax-free municipal bonds for certain accounts, usually as replacement
for bonds that have matured or have been redeemed by the issuer.
