Monthly Commentaries

It hasn’t happened before – May, 2005

There are some interesting dynamics occurring in the US bond market suggesting that term interest rates may stay low for a while, despite the Federal Reserve Board’s attempts to tighten the availability of money by raising short term interest rates. Historically when central banks hiked short term rates to slow the economy and control inflation, medium and long term interest rates also moved higher. In extreme cases, short term rates were pushed higher than longer term rates (known as “inversion”), signaling an impending recession and declining stock market. This time, contrary to most economists’ forecasts, yields on 5 and 10 year US Government bonds, known as “Treasuries” have remained stubbornly low while the Fed has nudged short term rates higher by 2% over the past year. It won’t take much more of a move up in short term rates to produce “inversion”, but now there is no sign of recession. In fact the US economy remains the engine of global growth, even as it slows to a 3.5% pace from 4% in late 2004. Inflation, although rising modestly, is by no means alarming since intense global competition will contain any escalating price pressures. So why have term rates remained low? The answer is largely attributable to the growth of the derivatives market, improving the ability to control interest rate risk. It goes something like this: Managers of mortgage portfolios know that when interest rates are low the mortgages are paid down quicker, causing a mismatch between the yield and average term of their mortgage portfolio and the fixed term, fixed rate funding that finances this asset.

To compensate, they buy 5 year and 10 year Treasuries to replace the lost assets caused by mortgage prepayments. However, vastly increasing growth in home ownership means that the size of outstanding mortgage portfolios is now 150% of the amount of US Government bonds outstanding. Furthermore, most portfolio managers were expecting term interest rates to rise and hadn’t protected their portfolios against mortgage prepayments. Consequently, there is quite a rush to buy term Treasuries with not enough to go around, pushing yields lower than almost everyone expected. This pattern will persist for quite a while before it is unwound and has positive implications for equity prices.

Combine a 4% yield on 10 year Treasuries (implying a price/earnings multiple of 25) with solid economic growth, and the 16 – 18 current multiple for equity markets seems inordinately low. Peter Sacks Managing Partner