"I busted a mirror and got seven years bad luck, but my lawyer thinks he can get me five."–Steven Wright

2007: A Continuing Balance Act
At the close of 2006, the U.S. Treasury market, as represented by the 3.1% return on the Merrill Lynch Government Fixed Income Index, recorded its seventh consecutive annual increase. In fact, returns in just about every category of financial assets increased during the year. Total rates of return were higher in the short end of the yield curve, as the returns on three-month and two-year Treasuries were 5.0% and 3.8%, respectively. The 10-year Treasury generated a return of only 1.3%. Why the disparity? Markets were sensing that the Fed’s tightening campaign was indeed over and taking the Fed’s cautionary tone toward inflation under close advisement.

For now, we’ll leave the issues of excessive global liquidity and the collapse of risk premiums aside, and take stock of the variables that may or may not be responsible for ending the fixed-income market’s winning streak during 2007.

• As measured by housing starts and new home sales, the declining barometric pressure of the housing market seems to have stabilized. Yes, the housing market has slowed dramatically, albeit for reasons having to do with the speculative build-up in inventory and pricing. The deceleration is certainly not coming from a deteriorating employment picture or higher interest rates. But, inventories of completed homes continue to surge and sales of previously owned homes have fallen for three consecutive months.
• Employment numbers have been stellar. The national unemployment rate remains at 4.5%. During December, non-farm payroll increased by 167,000 workers (well over twice the amount expected) and followed an upwardly revised figure of 154,000 added to the November job total. But, manufacturing employment fell by 72,000 workers during 2006.
• As the Fed continues to proclaim, inflation remains an issue. November’s producer price index rose by 2.0%. Not too pretty if that figure is annualized. But, recent declines in energy prices have yet to be factored into the equation. Also, consumer prices came in flat during November.
• The holiday season saw the currency markets focus on the notion that U.S. short-term rates may have peaked, while rates in other parts of the world are on the rise. Also, the U.S. current account, now equivalent to 6.8% of GDP, continues to deteriorate. During 2006, the U.S. dollar suffered 10.2% depreciation against the Euro. With the prospect of a deteriorating currency, there is doubt about international investors continuing to show up at the table. But, international investors keep showing up at the party. Foreign holdings of U.S. securities actually increased by $82.3 billion during the month of October. (That’s about $25 billion in excess of that month’s U.S. trade deficit.)
• Consumers seem to have the continued ability to spend. During November, consumer spending increased by 0.5%, the highest level since this summer. Consumer confidence indices continue to be above their historical averages. But, the savings rate continues to fall. It dropped to a rate of negative 1.0% in November.

On balance, we can’t rule out the Fed doing absolutely nothing with its targeted funds rate for an extended period of time. That’s increasingly the view of the implied forward markets. Currently, the forward market for short-term funds is forecasting a funds rate of circa 5.15% in six months’ time, decreasing slightly to 5.00% one year from now. Interest-rate futures are currently assessing only an 8% chance of a rate decrease over the next three months. This unchanged scenario would be all the more likely if inflation continues to slow and economic growth continues at its present “sustainable” annualized pace of 2.5% to 3.0%. Indeed, that appears to be the tone of recent “Fed-speak.” As an example, Cathy Minehan, president of the Federal Reserve Bank of Boston, recently presented her view that economic growth will rebound and inflation will moderate.

Market Volatility: Smooth Seas, at Least in Terms of Recent History
Contrary to today’s geopolitical headlines, in terms of recent history, market volatility is at its lows. In the short-maturity fixed-income markets, that’s surely been the case. From mid-2004 to mid-2006, the Fed conducted consecutive incremental rate increases of 25 basis points. Since June 2006, the funds rate has remained unchanged at 5.25%. Translation: there hasn’t been much volatility over the past few years. It’s a similar situation in other markets. As an example, it’s been more than three years since the S&P 500 has seen an intra-day price move of more than 2%. That’s a far cry from the volatility of the equity markets over the past four decades.

What does low historical volatility imply? Volatility is a primary determinant of the price of an option, whether equity- or interest-related. At this time, if you’re in the business of raising capital, options are cheap to buy and expensive to sell; if you’re in the business of investing, options are expensive to buy and cheap to sell. As a financial institution, now might be the right time to hedge against the outcome that would cause the most negative impact, be it declining or rising interest rates, as an example. The Seattle Bank’s Returnable or Prepayable Loan Advance and Floored Advance are examples of financing structures that contain the purchase of interest-rate options as a contractual feature.

From an investor’s standpoint, however, the reduced amount of market volatility has resulted in the diminution of spreads and risk premiums, particularly in the credit markets. These days, you’re not adequately compensated for taking on incremental risk. It seems tougher to support a case for investing out on the yield curve or for investing in dodgier credits.

The Consumer: Conspicuously Alive and Well
Richard Yamarone, chief economist at Argus Research (who is scheduled to speak at the Seattle Bank's 2007 Management Conference on May 24) recently projected that personal spending grew at a healthy annualized rate of 4.2% during the fourth quarter. Much of the strong degree of consumer confidence recently exhibited has undoubtedly been due to strong increases in workers’ hourly earnings. Wages are growing at the fastest clip since 2000. All of this is a bit of a mixed bag. True, strong wage growth and consumer confidence are effective antidotes to a sluggish housing market. On the other hand, let’s hope that the rate of GDP growth can keep step with wage growth. If not, that implies problems with productivity, and that could spell “inflation” to the Fed. With full employment and a confident consumer, the markets are sensing that the probability of imminent Fed ease is diminishing with each day. The figure “5.25%” could be emblazoned on our computer screens for some time to come.

John P. Biestman, CFA, is Director of Business Development at the Federal Home Loan Bank of Seattle.

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