Chandler Bond Market Review

The Federal Reserve Balance Sheet and Implications for Fixed Income Investors

The recent rise in Treasury market yields has some investors concerned the United States may be on the precipice of an inflation problem. The non-farm payrolls report has averaged an increase of 212,000 jobs over the past three months and the unemployment rate has ticked down to 8.2% versus 8.8% in March 2011, indicative of a strengthening economy. Similar to the first quarter of 2011, where the S&P 500 equity index returned 5.42%, equity markets have posted impressive positive results year to date in 2012. The direction of interest rates is also similar, Five year Treasury notes increased by 20 basis points (2.02% to 2.22%) during the first quarter of 2011 versus increasing by 21 basis points (0.83% to 1.04%) in the first quarter of 2012.

At Chandler we feel many of the issues that led to market volatility in 2011 remain mostly unresolved as we look forward into 2012. We consider the largest, but by no means only, lingering concern for market participants remains Europe sovereign debt risk and the impact on US markets. The European Central Bank (ECB) recently engaged in a form of quantitative easing via two Long Term Refinancing Operations (LTROs) to inject liquidity into the European banking system. The three year term on the loans offered by the ECB limits the time frame for the ECB’s balance sheet to expand. European sovereign bond yields recovered after implementation of the LTROs, and no additional such operations are expected.. In our view, the ECB continually does just enough to calm markets in the short term, but fails to provide a definitive long term solution. Finding the right balance of policies to promote fiscal austerity and simultaneously stimulate economic growth, so that even more austerity is not required down the road, will prove challenging for the Eurozone.

The recovery in the United States remains lackluster by historical standards. The soft recovery has contributed to the unemployment rate remaining elevated and less revenue for Federal, State, and Local governments. The inability of political leaders at the Federal level to find common ground on long-term deficit reduction is poised to impact markets in 2013. The rules put in place prior to the formation of the bipartisan “Super Committee” in 2011 require significant spending cuts across the Federal Budget in 2013, including expiration of the Bush tax cuts. Consensus estimates average a negative 2.5% – 3.5% impact to GDP in 2013. We question whether the markets are strong enough to absorb a contraction in government spending coinciding with a less accommodative Federal Reserve. When taking into account the totality of the economic backdrop, including the impact of a slowing Europe and the coming fiscal contraction in the United States, fears of accelerating inflation are not supported in our view.

The Federal Reserve has become a more transparent institution under Chairman Bernanke’s leadership. The committee remains steadfast in its official communication regarding its commitment to accommodative monetary policy, driven primarily by low rates of resource utilization and a subdued outlook for inflation over an intermediate time horizon. Since the onset of the financial crisis the Fed’s balance sheet expanded dramatically, increasing in size by over 3x. The composition of the underlying assets on the balance sheet has also changed, with the Mortgage Backed Securities component now being larger than the size of the overall balance sheet pre crisis. However we are now well past the most aggressive expansion of the Federal Reserve’s balance sheet via the first two rounds of Quantitative Easing (QE). Operation Twist (OT), set to expire in June 2012, is the latest iteration of unorthodox Fed policy. OT has not altered the size of the Fed’s balance sheet, just the maturity of the underlying holdings of the Treasury component. It is not only the actual level of interest rates or the size of the Fed’s balance sheet that influence prices in the capital markets – the rate of change in each of these metrics is also an important element. Post expiration of OT in June 2012, the potential risk is the rate of change will turn negative as the Fed’s balance sheet will start to contract and the average maturity of the underlying assets will shorten, potentially putting upward pressure on interest rates.

We believe any move materially higher in interest rates will be self-correcting. Real yields (interest earned less inflation) are so low, investors feel compelled to consider a more material allocation to higher risk assets for the potential to earn a real rate of return commensurate with historical norms. If equity markets and other higher risk assets deteriorate in a higher rate environment, we believe consumer balance sheets will deteriorate, and the already weak recovery will take a few steps backward.

Arguably one of the most significant legacies of Chairman Bernanke is his willingness to be creative with unorthodox tools available to the Federal Reserve to promote full employment and economic growth. Policymakers need to continue this trend of being creative with the Federal Reserve’s balance sheet to achieve its dual mandate of maximum employment and stable prices. If you can accept the hypothesis that historically low rates are a foregone conclusion over an intermediate time horizon, the Fed should avoid disrupting the recovery by lessening its support of the higher risk assets via low fixed income rates. A significant move lower in equity market valuations could potentially derail some of the positive aspects of the recovery experienced to date. We welcome the day when monetary policy can normalize. Normalization in our view is consistent with a Fed Funds rate of approximately 2.0%, Ten year yields of approximately 4.0%, and a contracting Fed balance sheet; however that day is not yet upon us.

William Dennehy II
VP, Portfolio Manager

RISKS AND OTHER IMPORTANT CONSIDERATIONS

This report is provided for general information purposes only and should not be construed as specific legal, tax, or financial planning advice. All opinions and views constitute judgments or relevant information as of the date of writing and such information may become outdated or superseded at any time without notice. This report is not intended to constitute an offer, solicitation, recommendation or advice regarding any securities or investment strategy. This information should not be regarded by recipients as a substitute for the exercise of their own judgment. Fixed income investments are subject to interest, credit, and market risk. Interest rate risk: the value of fixed income investments will decline as interest rates rise. Credit risk: the possibility that the borrower may not be able to repay interest and principal. Low rated bonds generally have to pay higher interest rates to attract investors willing to take on greater risk. Market risk: the bond market in general could decline due to economic conditions,especially during periods of rising interest rates.

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