Although he believes this interest rate cycle will be relatively mild, he thinks the next one could be far worse. "I see the potential for a conflict in the market between corporations and the government trying to raise money. ... I disagree with the forecasts of the administration and Congress because I think they are low balling federal spending, but if there's a strong economy it would help revenue, and if tax rates go up the conflict may not be extreme," he says.
Steve Bohlin, Thornburg Investment Management
Lead manager of Thornburg's Limited Term Income Fund, Limited Term U.S. Government Fund and the fixed-income portion of its Investment Income Builder Fund, an equity-income fund
Bohlin believes that two of the biggest issues affecting the bond market are rising interest rates and quality spreads.
At a minimum, he says, short-term rates have to go up because, at 1.5%, the Fed Funds rate is less than inflation. "We're running into a situation where Fed funds are at 1.5% and year-over-year inflation is at 3% if you use the CPI [consumer price index] and 2% by the PC deflator [private consumption deflator], so short rates at a minimum have to go up. A neuttral rate would be 100 to 150 basis points higher than right now," Bohlin believes.
If short rates go up, what happens to seven-, ten- and 30-year rates? "My personal opinion is we still have rates too low there. At a 3% inflation rate, a ten-year Treasury rate at 4.22 is not that attractive an investment to make," he says.
He believes interest rates will rise for at least another year, but at a measured pace. The wild card, he says, is price stability, and if that can't be achieved while rates go up, the Fed many have to raise rates more quickly than planned. However, he's figuring the Fed won't want or need to do that. First, the economy is strong, but it's not raging. Second, a huge percentage of it is involved in the finance business in some form, and as a result a rapid rise in short-term rates would cause a huge amount of pain.
Oil prices also are a concern as well, but an important question is whether higher oil prices will be inflationary or deflationary. Higher oil prices tend to slow consumer spending and reduce discretionary income, but oil prices also affect things that consumers can't cut back on so easily. "When you take into account simple things like food, 40% of the cost is in transportation. So it's a large question, whether $46 oil will be inflationary or deflationary," he says.
As far as quality spreads go, normally when the economy becomes attractive, quality spreads become tighter. "Unfortunately, we've already seen that. We've had tremendous spread tightening over the last couple years, to the point where you wonder where we can go from here. Any kind of perceived slowdown is going to force spreads out wider even as rates are rising. I think that's very negative for the bond market, and it will force new-issue rates to go up higher," Bohlin says.
As a result, he's staying shorter with his bond investments. "I still think the two- to three-year segment is attractive, but I just don't think the ten-year on out is attractive. I'm staying high quality. In high-yield and emerging markets, you have to use a sniper-shot approach as opposed to a scattergun approach. Two years ago, you could buy a basket; it didn't matter what you owned," he says.
Today, he says, he doesn't believe any bond sectors are cheap, although an occasional company will provide opportunities. Overall, he's steering clear of emerging markets and limiting exposure to high yield. "I think one of the best approaches in this kind of marketplace is to stay short and ladder out your maturities so you're not just sitting in cash and not just receiving a 1.5% yield, but you're not taking on all the price volatility of a ten-year or 30-year," he said.