From 2000 through 2004 the Federal Reserve did everything in their power to stimulate a sluggish US economy. The Fed implemented an “easy” monetary policy and lowered the Fed Funds Rate from 6.50% in May of 2000 to 1.00% in June of 2003.

In 2004 the US economy started to show signs that the current recovery had “staying power”. In June of 2004, the Federal Reserve announced that it was time to take some of the stimulus out of the economy to prevent the economy from overheating and the rate of inflation from rising dramatically. The Fed announced it would begin raising interest rates at a “measured” pace – which means, a continuous series of small interest rate hikes.

The Federal Reserve increased the Fed Funds rate sixteen times, from 1.00% to 5.00% during the two year period from May of 2004 through May of 2006. On May 1, 2005 the yield on the two-year US Treasury Note was 3.65% and the yield on the ten-year US T-Note was 4.20%. By April 30, 2006 , the yield on the two year US Treasury note had climbed to a 4.89% yield and the yield on the ten year note moved to 5.07%!

 This “flattening” of the yield curve is common during a period when the Fed begins a tightening cycle (increasing interest rates).

The longer end of the yield curve anticipates future Fed action and prices it into the market three to twelve months before the Fed actually raises rates, while shorter-term securities move in lockstep, with the Fed Funds Rate.

The ten-year US Treasury note has backed up almost 100 basis points since May of 2005 and nearly 200 basis points since May of 2003.

The Year in Review - Stocks

The “bull market” was extended in the equity markets during fiscal year 2005-06, with all major markets producing double digit rates of return!

Portfolio Strategy for 2006

I believe short-term interest rates may move slightly higher in 2006. The question at this point is “how high will they raise interest rates?” I believe the Federal Reserve may only need to nudge rates slightly higher from the current 5.00% level.

Currently the yield curve is flat (by historical standards), which means the difference in yield between short-term bonds and long term bonds, is very slight! The flat yield curve is forecasting a slowdown in economic growth, which would be a positive development for the bond market. Once the Federal Reserve announces they will suspend future Fed Funds Rate hikes, the bond market should rally, increasing the market value of your fixed income portfolio.

The equity market has advanced quite impressively since 2002. However, there is a distinct possibility that higher interest rates and stubbornly high energy costs will create a drag on economic growth and the economy could lose momentum in the latter half of 2006 or in 2007.

We feel it may be prudent to do more to protect the equity portion of your portfolio from a market correction in fiscal year 2006-2007.

We will continue to watch for meaningful developments which could affect your portfolio. In that event, we will recommend asset allocation shifts designed to preserve the value of your retirement assets. 

On December 13, 2005 , the Federal Reserve raised the Fed Funds Rate another 25 basis points or .25 of 1%. Since May of 2004, the Fed has increased the Fed Funds Rate 13 times, from 1.00% to 4.25%.

The Federal Reserve is raising short-term interest rates because it is concerned about a potential inflationary threat. The rapid appreciation in the price of oil has pushed the Consumer Price Index ( CPI ) up dramatically over the past 12 months!

With Gross Domestic Product ( GDP ) currently at a healthy 4.00% rate, it is important to note that the Federal Reserve is not trying to slow economic growth, but rather to keep a damper on inflation!

The Fed has a very difficult task ahead. It is trying to slow the housing sector and prevent inflation from getting out of hand in the face of higher energy costs. They have to increase interest rates just the right amount, at just the right time, to dampen inflationary pressures, without pushing the domestic economy into a recession.

The yield curve continues to flatten as the Federal Reserve pushes short-term interest rates higher.

The Fed has to be careful it does not cause an inversion of the yield curve (short-term rates are higher than long term rates) because the “inverted yield curve” is the most accurate predictor of a recession.

Gary Karshna, Investment Manager

Oil has held center stage in the economy since June 1, 2004, and the spotlight grew more intense as the price climbed over $40.00 per barrel. Over the past 12 months, crude oil prices are up 60% and up 800% from their low in December of 1998.

Oil prices shot up to $55 per barrel, before the recent correction, which brought prices down to approximately $44 per barrel. Despite the recent correction, the question we would all like to have answered is “how long will they stay at these lofty levels and how will it affect the economy and my investment portfolio?”

Disruptions in supply such as; the war in Iraq, political problems in Russia and strikes in the oil fields of various African countries, etc., affect oil prices in the short-run. However, if increased demand from countries like China & India continue for an extended period of time, oil prices could remain above $40 per barrel, longer-term.

How will oil prices impact the economy? There is no question that higher oil prices have the potential to slow the economy quite dramatically. If consumers have to pay more for gasoline and home heating oil, that leaves fewer “discretionary” dollars to spend on other things. In effect, it is like imposing a “tax hike” on the average American.

Federal Reserve Chairman Alan Greenspan recently mentioned that if oil prices remain above $50 per barrel, Gross Domestic Product (GDP) would have to be reduced by ¾ of 1%. That means GDP would be reduced from 3.50% to 2.75%, hardly a robust economic outlook!

What is the impact on your investment portfolio? Slower economic growth would push bond prices higher but would reduce the potential for price appreciation in the stock market!

Gary Karshna, Investment Manager

The last two decades have been good to fixed income investors!  Cumulative returns for bonds have averaged 8.6% since 1990, neck and neck with US equities over the same period and with less volatility. But looking ahead, bond-market investors will have to work harder.  Overall bond market returns in the next few years are unlikely to match those of the past two decades.  Why?  Because the last two decades spanned the transition from the worst bear market for bonds in US history (1965-1981) to a prolonged period of falling interest rates (1985-2003), the best of all possible worlds!

We started this “golden age” for bonds with inflation, interest rates and budget deficits all at historic highs.  Since then, globalization, productivity growth, and monetary discipline brought steady disinflation that lent strong support to credit markets.  In addition, the cold war’s end and fiscal discipline helped shift government deficits into surpluses, helping “real” interest rates fall from 9.6% (their peak in 1984) toward 2.8% (the long-term average).

The current macroeconomic environment poses risks to bond investors.  Rising government borrowing needs, a weaker dollar and steps to fight deflation by global central banks will eventually re-inflate the global economy.  In addition, a slackening commitment to globalization due to rising protectionist sentiment, could amplify these risks greatly. 

Against all expectations, stocks and bonds were positively correlated (returns rose and fell together) for much of the 1980’s and 1990’s, as productivity gains and declining inflation benefited both markets.  Now, however, both asset classes should track the economic cycle more closely – and stock and bond prices should move in opposite directions.

Invest cautiously.  The easy money has been made in the bond market! 

This article does not provide individually tailored advice and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it.  All opinions, recommendations and estimates expressed in this article constitute our judgment as of this date and are subject to change without notice.  Excerpts taken from Forbes Magazine Article: Market? Shaken. Bonds? Not Stirred, written by Amy Falls, Global Fixed Income Strategist, Morgan Stanley.

Professional Investment Managers are constantly measuring the "risk level" and the "potential return" of your bond portfolio, under a variety of different economic/interest rate scenarios. One of the best measurements of the risk/reward ratio is something called "duration". Duration is a term that you may have heard someone use before, but you may not know exactly what it means or how it relates to bonds.

A textbook definition is: the average percentage change in a bonds value (price plus accrued interest) under shifts in the U.S. Treasury curve +/- 100 bpi (1%). In other words, it calculates the percentage change in the value of your bond portfolio if interest rates move up or down in 1% increments. Duration is typically measured on a scale of 1 to 30. A portfolio consisting solely of 1 year U.S. Treasury STRIPS will have a duration of 1, and a portfolio consisting solely of 30 year U.S. Treasury STRIPS has a duration of 30.

Remember that there is an "inverse" relationship between bond prices and bond yields. When interest rates "fall" the market value of bonds increases and when interest rates "rise" the market value of bonds, decreases. The magnitude of these changes in the market value of your portfolio can be measured by the duration of your portfolio.

As an example, lets assume the current duration of your fixed income portfolio is 9.27. If interest rates move down 100 basis points (one percentage point), the value of your fixed income securities will increase 9.27%. Keep in mind that this 9.27% increase is tacked on to any interest received to date (the coupon rate of return of your portfolio). Therefore, if your coupon rate of return is 6.05% and interest rates fall 100 basis points, your total return is a positive 15.32% (6.05% coupon rate + 9.27% = 15.32%) increase in market value. Conversely if interest rates move up 100 basis points the total return in your fixed income portfolio will be a negative 3.22% (6.05% - 9.27% = -3.22%).

The chart below, "graphically illustrates" how the total return of a fixed income portfolio will change under a variety of interest rate scenarios.

As fixed income managers, we will adjust the duration of your fixed income portfolio, based upon interest rate forecasts. If interest rates are expected to "fall", we will increase the duration of the portfolio (by selling shorter-term instruments and acquiring longer-term positions) to maximize the profit making potential of the portfolio. If on the other hand, interest rates are expected to rise, we will "shorten" the duration to minimize the loss in market value.

Successfully anticipating changes in interest rates is extremely difficult, but it can dramatically affect market value rates of return in your fixed income portfolio.

Calculating "duration" is one of the tools that we use to measure the risk/reward ratio before implementing an investment strategy designed to improve the rate of return in your fixed income portfolio.

December 1, 2002

The drumbeat of negative economic reports in early 2008 isn’t letting up. Surveys of purchasing managers show that manufacturing and non-manufacturing activity is contracting. The drop in home sales is unrelenting and house prices are falling faster, not more slowly. Now commercial construction is starting to tumble, too as the home mortgage mess spills over into that industry. Even as job markets weaken, higher prices are sapping consumer buying power. The message seems clear; hopes are fading that the US economy can avoid recession.

At the center of the growing pessimism is the US Consumer. Adjusted for inflation, consumer spending failed to grow in December and January.

The most immediate stress is lost buying power because of surging prices for food and fuel. For the past three months, consumer spending has fallen for everything except basic necessities.

The bigger problem is that households are losing all the cushions they have depended upon in the past to absorb these kinds of blows. Up to now, consumers have augmented their purchasing power by further drawing down their savings, using credit lines, or tapping home equity lines of credit or other assets. Now, falling home values and declining stock prices are rapidly eroding household wealth. Tighter credit is limiting borrowing for big ticket items, such as homes and cars.

The new danger is that this decline in spend able resources will suddenly push households to increase their savings - draining even more money from the system. Consumers have been able to live with skimpy savings in recent years because big gains in household assets have allowed them to spend some of their record wealth and to borrow more, all while maintaining a healthy balance sheet. Now that’s changing.

Based upon the current pattern of stock market losses and falling home values, household net worth is estimated to have declined by about $1 trillion in the fourth quarter and another $2 trillion this quarter. That would be the largest drop since the tech bubble burst in 2000.

If consumers succumb, the fatal blow will most likely come from a flagging job market. Concerns there, based on reports through February, are mounting, raising the risk that consumers will have no choice in coming months but to save more and spend less.

Gary Karshna
Investment Manager