It seems as though the world security markets are in turmoil. As interest rates have risen around the globe, there appears to be plenty of causes for the financial press to focus on: rising oil prices, increasing budget deficits, election uncertainties, a war that is not going well, and the prospect that the Federal Reserve will raise short-term interest rates. However, these trends and expectations have been in-place for several months. What caused the vicious drop in Treasury bond prices? Why were REITs blasted at the same time? Why have emerging country bonds been hammered and domestic high yield bonds decimated? Why are the stock markets in China, Japan and India cracking? And why has the U.S. stock market been declining?

Much of the blame for these knee jerk reactions in the world capital markets has been construed to be the trading activities of hedge fund managers. (Remember when Long Term Capital Management needed to be rescued after the global bond market crisis of 1998?) A Wall Street Journal article last week said it very well: “All these markets are taking a hit because hedge funds and other speculators had piled in with borrowed money that was many multiples the capital they had. Employing so-called carry trades, they borrowed dollars at low interest rates and invested the proceeds in higher-yielding assets. But with U.S. interest rates rising, many of the trades are either becoming or threatening to become unprofitable. As a consequence, the speculators and other investors are making a mad dash for the exits, dragging markets down with them.” Just as when one shouts, “fire” in a crowded theatre, hedge funds trample over each other in the attempt to be the first out the exit. Illiquid markets, wherever they may be, limit simultaneous exits and this usually results in a brutal decline. When a significant deterioration occurs in a very liquid market, such as Treasury bonds, one wonders if it’s just the hedge funds (a.k.a. knee jerks) that are deleveraging (flattening out long or short positions) or is something else going on?

As you will recall, when bond yields go up, prices go down. On March 24, the yield of the ten-year Treasury bond was 3.71%. By May 13, the yield was 4.85%. This change in market yield equated to a price decline of 23.5%! Much of the consternation was the result of the employment data reported for March and April that was so positive as to suggest that the Federal Reserve would likely raise rates in the near future. Penciling-in those rate increases convinced many leveraged hedge funds that the cost of carrying their Treasury bond positions would be unprofitable. Billions of Treasury bonds were sold between those two dates by owners that dearly needed to reduce their leveraged exposure. In turn, other markets, both domestic and foreign, were impacted by just the prospect of higher short-term rates around the globe including those in China, Australia, Canada and the United Kingdom.

Aside from a prospective increase in short-term rates, long term bond yields (and earnings yields) are determined by inflation expectations (among other things). After all, it’s not as though inflation had become a problem. Over the last twelve months the inflation rate for the core consumer price index (which excludes food and energy) is around 1.7%. Evidently, the bond “vigilantes” are factoring in a significantly higher inflation rate. One way of viewing the momentum of the inflation rate is to observe the trend of this index. Chart 1 depicts the core CPI index over the last two years. I have also included a 3-month moving average of the same index to smooth out irregularities caused by faulty seasonal adjustments. Between December and April the CPI increased at an annualized rate of 3%. Is this the rate of inflation we can expect in the future?

As we mentioned in our December 10, 2003 commentary (see The Hokey Pokey), we envisioned an inflation rate of 2.6% in 2004 and 3.0% in 2005, well above what many economists were suggesting then (or even now). We said that long-term rates (the 10 year Treasury bond was then 4.29%) could go up by 100 basis points over the next 6 quarters. We did not envision the bond market assuming that 3% inflation was probable for 2004! As you may recall, the consumer price index is divided into two major components: commodities (i.e. goods) and services. The former accounts for roughly 40% and the latter for 60%. The inflation rate of services has averaged a very steady 3.2% for the last nine years. The more variable component of the CPI is that for commodities. Excluding energy, the commodity sector is highly correlated with unit labor costs. (See Chart 2 of The Hokey Pokey). However, we don’t expect unit labor costs to become a problem until 2006. The unusual surge in the commodity sector this year is due to energy costs and higher than normal food increases. Both of these components should cool down later this year and allow commodities to return to more normal increases. Below are our forecasts for the commodity and service sectors.

CONSUMER PRICE INDEX COMPONENTS

The prospect of rising interest rates changes many things. However, the large amount of consumer debt tied to short-term interest rates precludes any drastic steps by Allan Greenspan & Co. Nonetheless, we believe that there will be 75 basis points of tightening this year. If we are correct in our assumption that energy costs will remain flat from here on, then the trend of commodity price increases should revert to more modest levels. This suggests that there is little danger of runaway inflation until industrial capacity utilization and employment rates are at much higher levels. If gasoline prices continue to rise due to insufficient refining capacity, then commodity prices will cause some additional upward pressure on the total CPI. Chart 2 depicts our 10-year Treasury Note model for the next 18 months. By the end of 2005, ten year Treasury notes could be yielding 5.3%, up from the current 4.7%. These higher interest rates, both short and long, will provide an incentive for the knee jerks to continue deleveraging. It should be noted that price-earnings ratios for the stock market are also likely to decline in 2005 and 2006.

John K. Dolan
Brian E. Schaefer

S&P 500: 1115
Treasury Note: 4.64%
May 27, 2004