July 2009

More Positive Signs

By Brad C. Stewart, Senior Vice President/Chief Investment Officer

Wow! Talk about instant gratification. In last month’s FYI we discussed my concern regarding the funding of the federal budget deficit, its impact on interest rates and if the Federal Reserve and the administration have a plan on how to address this potential problem. Well we can only hope they do, because after a few unrelated events took place, the bond markets began to extract their pound of flesh.

The two year treasury moved from a yield below one percent to just shy of one and one half percent. This occurred in a matter of three work days. The first thing to occur was the announcement of a non-farm payroll number that was much better than expected. When an economic number is better than expected, U.S. Treasuries usually fall in price and rise in yield. The price is inversely proportionate to the yield. With the exception of a few days back in February, the yield on a two-year treasury note traded below one percent since November 28, 2008.

This may not come as a big surprise, but since June of 2008, the average yield on a ten year treasury was 3.29 percent. Since May 22, 2009 the ten year has consistently yielded above that level. The yield curve has steepened dramatically in the last month, meaning the spread between short and long dated treasuries has widened. The reasons are because the economy is improving and partially because of all of the debt that is being funded to stimulate the economy. One could surmise that as the yield on the ten year treasury increases, the rate on a thirty year mortgage also increases. On the surface this could suggest the economic recovery will slowdown. If we were not beginning from such a depressed level, that might be true. However, historically a 5.5 to 6.0 percent mortgage rate is quite attractive.

The next comment may seem unusual. If treasury rates continue to increase we should take that as a positive sign. Why, because interest rates are increasing as a result of the economy showing signs of putting this recession behind it. Life should begin to return to normal and the fear that has engulfed the country will begin to dissolve.

Other positive signs that the economy continues to improve are being announced everyday. The Leading Economic Indicators (LEI) was announced and suggested that a recovery was forming. Also the stock markets have held in there very well. The declines, when they have occurred, have usually been in the low double digits, not in the hundreds of point declines we were experiencing earlier this year. Stephen Wood, who helps manage a $136 billion portfolio, recently stated; “The market has run out of fantastic reasons to sell” and “Those Armageddon, Great Depression, worst case scenarios being priced in a few months ago are now a low probability, and the recovery reflects that.” I think his comments sum up what I am trying to convey very well.

I still believe there is still a lot of heavy lifting to do. The unemployment rate will continue to rise. President Obama’s forecast for 10 percent unemployment is not out of the question. When the President of the United States publicly recognizes this, I would suggest that 10 percent may be lower, than what will eventually be the peak. This will breed uncertainty as to when the recovery will take hold and the good times will begin to overshadow the current mess.

I have said that interest rates will rise. I now believe that the fear of inflation will not be the catalyst that is responsible for rates rising, at least not for some time. Instead the true need is to increase interest rates high enough to make them attractive and entice buyers, especially foreign buyers, to commit to purchases. The issuer, our government, will have little choice but to raise those rates to attract these funds and finance the huge deficit.