Leading bond managers debate what's ahead.

A Financial Advisor Special Report

    At this year's Financial Advisor Symposium, a group of elite bond fund managers met on September 27 and held a panel discussion on the challenge of investing in fixed-income securities today. The panelists included Laird Landmann, a risk manager at Metropolitan West Asset Management, who manages many of their absolute return vehicles, including the Total Return Fund, which was Morningstar's "Bond Fund of the Year" last year; Bill Healey, head of interest rate products at GE Asset Management; Dan Fuss, manager of the Loomis Sayles Bond Fund, another Morningstar Bond Fund of the Year, and Jay Chitnis, managing director and chief investment officer at YieldQuest, which does a lot of managed portfolios and some mutual funds of its own. The panel was moderated by Financial Advisor Editor-in-Chief Evan Simonoff.

Simonoff: The economy has slowed significantly in the last two months and inflation indicators have moderated. Does this represent a major inflection point for the economy and the bond market or could it just be a statistical blip?

Landmann: The bond market is suggesting that we are at the inflection point here. Two-year rates are now over 50 basis points below the federal funds rate, very short-term rates, indicating that certainly the market is anticipating the Fed will be easing very shortly. We think whether this is an inflection point or isn't will depend on how hard the housing market or the real estate market, particularly residential real estate, reacts over the next six to twelve months. But our belief is that this Federal Reserve will be a little bit slower in terms of getting into an easing cycle here.
    Certainly when Greenspan was Fed chairman he talked about the three structural problems, structural deficits in the economy, and a very low savings rate in the U.S. and of course the speculative boom in the housing market. We have only begun to see those things correct very slightly, and our feeling is that Bernanke will wait and let this play out a little longer before we actually move into an easing cycle. So we don't think that we are necessarily at the inflection point for the economy, the economy is going to slow, 4%  growth is not sustainable when you have 4% unemployment. So certainly labor productivity is going to be strained here, and it is just natural that we will have a slower rate of growth for the next couple of quarters, not likely a recession.
Simonoff: Bill?

Healey: We think that this is a temporary slowdown. Look at what just happened with the energy market. Over the summer we were concerned about energy sapping the consumer and we have had a tremendous fall off in natural gas prices, heating oil, oil and in particular gasoline prices. So there are some things in the short term that will help the consumer rebound, fourth quarter, first quarter.
    But, in terms of inflection point, one of the concerns that we have is around the housing market. Some people have suggested 50% or 60% of the GDP growth over the last three years has been related to housing. And if you do get a major fall-off in housing, it could trickle into that recession that people are talking about.

Simonoff: Dan?

Fuss: Our basic thought is that the secular decline in interest rates ended in the second week of June of 2003, and we are just completing the transition cycle from a 20-some-year decline in interest rates to a long period of rising interest rates. Nobody knows the future, so I'll talk about the future. On a shorter-term basis the economy is slowing. When you get into a situation where the secular trend is changed, the behavior of interest rates by maturity completely changes. For 20 years the short rates led the long rates down-in other words it is the administered rate-and  the Fed rate was your lead.
    Now, as you go through a period like this it flips and the long rate in effect leads the shorter rates down. A natural outcome of that is that you are going to get an inversion that could fake you out. You will say, gee, the Fed is tightening. The Fed isn't tightening, quite the reverse. The open mouth is towards east, the action will lag so that the long rates lead you down. Use the ten-year as a point of reference, we peaked roughly at 5.25%. We are getting close to 4.50% now, a lot of technicals kicking in that ought to drive it below that on a choppy basis. But that 4.50% looks like a level for it to level out.
    It is the labor force that the Fed will key off of. There is weakness here and there, but it won't show up in the overall numbers. The rate of growth and employment in this past business cycle has really been terrible. The only one like it was in the early 1960s. So you would anticipate that the labor force growth won't drop too much; if it does the Fed will then act. Our guess is that there will be three Federal Reserve rate cuts but they won't start until over the wintertime, and next year at this time we will be at 4.50% and the open mouth policy will be swinging the other way.

Chitnis: It is a little dangerous being on the opposite secular side of the fence from Dan, but that is the position we find ourselves in and we think it is important to have a good grasp of the secular trend. We feel the secular trend is towards deflation, not towards inflation, for two reasons, which are very much related. There is an excess supply of capital in the world and an excess supply of labor in the world, and any time you have an excess supply of anything it leads the price of that commodity or item to come down. So when you have that excess supply of capital and labor, when you have a recession in the West, that is going to feed itself in the form of much lower interest rates.
    Whenever the next recession comes, it would not surprise us at all to see ten-year Treasury rates be below where they were in June of 2003, which was that 3.1% level. What you have seen in the last three months is how the bond market will react when there is even a whiff of deflation in the air. The reason rates went down by 75, 65 basis points in the last three months is, we believe, because of the secular backdrop of deflation vs. inflation.
    Fortunately we think that the Federal Reserve chairman understands the deflation threat and therefore there is a lower probability that it would happen. That in our opinion is the secular backdrop; there is a bias toward lower rates, not higher rates, at least getting into the next recession, which we think is this side of 2010, if not in 2007 or 2008. What you saw in June through this week was the way the bond market will react when there is what we think is a whiff of deflation. What you had is a slowdown in the economy, a deceleration in the inflation rate, perhaps a turning over, a cresting of inflation, and that's why we are where we are in terms of rates. On the flip side, we would agree with the first two gentlemen insofar as there is a feedback loop mechanism natural in the economy, whereby lower gasoline prices not only induce teenage children to drive more, they induce everybody to drive more, and even if they don't, they are going to Wal-Mart more and they have an extra few dollars in their pocket. There is a feedback loop mechanism in the economy that allows a little bit of reignition.
    There is also a feedback loop in interest rates. Just last week, The Journal reported that there was a "spike in refinancing." Folks have ARMs that are adjusting upward and they are refinancing, which is preventing higher mortgage payments. All of those things are redounding for the benefit of the economy.

Simonoff: Do you think the Fed has completed the tightening cycle, or is the jury still out? Dan indicated that he thought there would be three cuts starting in March.

Fuss: That's right, three cuts starting in March.

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