Investing
Is a Recession Ahead? A Bond Buyer’s Debate
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By ROBERT D. HERSHEY Jr.
Published: September 3, 2006
MANY times over the last two years, it was quite clear what the Federal Reserve’s next decision on interest rates would be: an increase, very likely one-quarter of a percentage point.
The Fed made 17 such well-signaled moves during that time, raising its benchmark short-term interest rate to 5.25 percent from a scant 1 percent in mid-2004. But the Fed’s script changed at its last meeting: it decided to do nothing.
This decision has inspired some of the sharpest disagreement among professionals in recent memory about the outlook for the bond market, with a growing number of specialists turning vocally optimistic while a sizable group of skeptics expects a resumption of rate increases that will continue to hobble fixed-income securities. Inflation, these skeptics note, is rising at a rate that has already made the Fed uncomfortable. The Fed’s policy-making committee is next scheduled to meet on Sept. 20.
What is an income-oriented investor, who long endured yield percentages often associated with low-fat milk, to do?
Because the Fed has said that its course will depend on the “evolution of the outlook” for the economy and inflation, it seems worthwhile to form a view of business prospects. Will the housing dip become a full-fledged slump? How many people will curtail visits to the mall because of gasoline prices?
A recent survey by Merrill Lynch may be a starting point. “The specter of recession looms large,” it concluded after polling 161 investment managers, “with a third of our U.S. panel believing recession is ‘likely’ in the next 12 months.”
This, of course, is the stuff of a bull market for bonds, and William H. Gross, chief investment officer of Pimco, which manages $650 billion of fixed-income securities, is a true believer. Indeed, his performance suffered in the first part of the year; then things began to turn his way. This summer, the yield on the benchmark 10-year Treasury bond, for example, eased to about 4.72 percent from 5.25 percent in late June.
This, he said recently, “is discounting a lot of economic weakness and lots of Fed cuts in 2007.” He acknowledges that inflation by many measures is indeed creeping higher, but he calls it a traditionally lagging indicator that will soon retreat.
Though the yield on the 10-year Treasury has already fallen nearly half a percentage point, and Mr. Gross has extended the average Pimco bond maturity to 10 years from 7, he argued that this was only the beginning. “A typical bull market in bonds has been about 250 basis points, 2½ percent,” he said. “So were this to follow historical parameters, you might see the 10-year fall from 5¼ to as low as 3 percent at some point, maybe in 2008.”
Mickey D. Levy, chief economist at Bank of America in New York, espoused the opposite, a bearish view, though he was less forceful about it.
“I think it’s in the cards that inflation is going to drift higher through year-end,” approaching 3 percent, excluding the volatile energy and food components, he said. And that, he added, means “continued upward pressure” on interest rates.
“The bond market’s been very sanguine about inflation, and I think rates are a little too low here,” Mr. Levy said, with investors acting on what he called an erroneous assumption that an economic slowdown necessarily reduces inflation. History suggests that it does not, Mr. Levy said; in his view, no cuts by the Federal Reserve are even in sight. (He thinks that the economy will continue to grow at a moderate pace of 2.75 percent to 3 percent.)
An even more bearish analysis, from Lehman Brothers, predicts not only a quarter-point rate increase by the Fed this month but also a second one, bringing the Fed funds target rate to 5.75 percent by year-end.
Of course, the Fed directly controls only the shortest-term interest rates; investors’ expectations of inflation determine them for the longer term. In fact, raising short-term rates can reassure investors in longer-maturity issues that the Fed won’t let the economy overheat to the point of unleashing inflation, and its vigilance helps depress long rates.
That the 10-year bond now yields substantially less than the target rate reflects other forces as well, like heavy purchases of Treasury issues by foreigners awash in dollars earned from trade surpluses. But important as it is for bond investors to monitor the economy, this may not be the key to profits.
Burton G. Malkiel, a professor at Princeton known for the view that the stock market is so efficient that price moves are unpredictably random, says he believes that this is even truer for bonds. While you have a better-than-even chance of forecasting the economy in the short run, Professor Malkiel said, “I’m not at all sure that you are more than 50-50 in calling turning points.”
And while he thinks the Fed has probably finished its tightening, “whether we can make predictions about the bond market is what I’m much less certain about.” One reason: bonds, unlike stocks, show no long-run trend.
For investors seeking a middle ground, the dominant view seems to be that rates have peaked but that there is no urgent need to load up on distant-maturity bonds, which would benefit most from receding bond rates.
“We think the economy is headed for an extended period of slow, below-trend growth,” said Edward F. McKelvey, senior economist at Goldman Sachs. The Fed’s next move “will be a cut,” Mr. McKelvey added, though probably not until next spring.
While that means it would be profitable to extend maturities, it is still early. “There’s always an issue of how we perceive things against how the market perceives them,” he said. “The market may need a little more convincing before it’s really appropriate to go longer.”
Robert B. MacIntosh, a director of municipal bond investments at Eaton Vance, is similarly inclined. The Fed has “reluctantly” paused, he said, and will be in no rush to reverse course. Investors can buy bonds gingerly now, he says, if they keep these caveats in mind: that tax-exempt issues are not the screaming buys they were earlier in the year; that you don’t want to own bonds that can be called when rates ease; that maturities of 15 years should be the limit; and that you don’t sacrifice quality for higher returns.
“If there’s ever a time you ought to steer clear of high-yield stuff, it’s right now,” when the economy is cooling, Mr. MacIntosh said.
Bond mutual funds that use leverage, analysts also note, have for the most part lost this advantage. It is no longer possible to borrow money at low short-term rates and pump up returns by using the borrowings to buy longer bonds paying a higher rate. This benefit, called “carry,” disappeared when short rates exceeded long rates.
ANOTHER mainstream view is expressed by J. Mark Joseph, president of Sentinel Wealth Management, a financial planner in Reston, Va. “We’re fairly dubious” about the Fed’s next move, he said, adding that he has tried to discourage the few clients who have asked whether this might be a good time to consider, say, the 10-year Treasury bond.
Any decline in rates won’t be rapid, Mr. Joseph said, and various studies have found that, over the decades, there is little extra reward for the risk investors assume when they commit to bonds with maturities of more than five to seven years.
Client portfolios at Sentinel average about two years before maturity for the fixed-income component, about 40 percent of the total, with increased purchases in recent years of the bonds of other developed countries.
Emerging-market bonds, which turned in big gains last year, are now suspect, advisers say. “You’ve always got to be careful when you’re coming up with blistering performance,” Mr. Joseph said. “It precedes a decline in many cases.”
The supercautious investor is likely to remain in highly liquid instruments like savings accounts — most advantageously at Internet banks — as well as money market funds and Treasury bills and notes.
Peter L. Bernstein, the financial adviser and analyst, declared in a recent issue of his newsletter that whatever one’s view, Treasury securities are splendid insurance against an unknowable future. “The long end is a hedge against deflation,” he wrote. “The short term is a hedge against inflation because you get a higher rate of interest every time you roll them over.”
