Fall 2004
tightening of U.S. monetary policy with a .25%
increase in the Fed Funds rate in both August and
September. Alan Greenspan, the Chair of the Fed-
eral Reserve, had been quite positive in his com-
ments on the economy over the summer. A strong
and sustaining economic rebound left no lingering
excuse for the admittedly .emergency. low levels
of administered interest rates that were the legacy
of the September 11th, 2001 terrorist attacks and the uncertainty in the prelude to the Iraq war.
The Fed.s press releases took care to point out that
monetary policy remained accommodative but that
it remained ever .vigilant. in its commitment to
price stability. Local Fed Governors also continued
the .normalization. theme with their comments on
a reasonable level for short-term interest rates. To
paraphrase: .much higher.. Clearly, Alan Green-
span does not want the financial markets to be sur-
prised as in his 1994 tightening.
Just to prove that every generation of investors
must learn its own lessons, the bond market rallied
over the summer. Tighter monetary policy and
much higher energy prices led to higher bond
prices and lower yields. Making a mockery of for-
mal economic education, the financial press came
up with the ultimate perversion of economic ortho-
doxy: .BOND PRICES RISE DUE TO HIGHER
OIL PRICES.. Yes indeed, oil at $50 a barrel has
become the ultimate support for low interest rates
due to its deflationary effect on consumer spend-
ing.
Perhaps higher energy prices and widespread com-
modity price increases might trouble those obsoles-
cent investors trained and experienced in the dark
ages before falling interest rates, but it clearly did-
n.t give pause to new millennium portfolio manag-
ers. Being simple folk, economically, we can.t
really subscribe to this new age approach to the
bond market. When the central banks tighten pol-
icy, there is less money available for financial in-
vestment and interest rates will rise.
We have believed for some time that the 1990s
economic model has changed dramatically. In the
1990s, freer trade, particularly with mainland
China, meant that the West exported its light manu-
facturing offshore. Cheap labour and unregulated
commerce dramatically changed the terms of trade.
China became the production division for most
western economies .a la Wal-Mart.. This trend
was and remains a strong deflationary force.
What is making a big difference now is the use of
the U.S. dollar proceeds of the Chinese and other
Asian exports. The Chinese and other exporters
were content in the 1990s in investing their earn-
ings in new plants, equipment and vast amounts of
U.S. government bonds but now an increasing
share is now being spent on domestic consumption.
This has contributed to the strong upwards pressure
on commodity prices. It has also caused a huge
logistical bottleneck in ports on both sides of the
Pacific.
The price of steel, oil and many other commodities
is now reflecting large demand from China and
other developing nations. This has been good for
Canada, as a commodity and net energy exporter.
We do not see this changing anytime soon. The
large foreign exchange reserves of China means
there is little chance of a repeat of an Asian cur-
rency crisis as in 1998. A more likely risk is U.S.
dollar weakness if the Asian exporters lose their
interest in U.S. dollar investments. This would add
to rising commodity prices in U.S. dollar terms and
be very negative for the U.S. economy and infla-
tion.
The renaissance of commodities is also changing
the complexion of the financial markets. With
commodities looking better than any time since the
late 1980s, we are seeing a major rotation into
commodity stocks and even commodity invest-
ment.
Hedge funds are touting their ability to di-
rectly invest in commodities as an alternative to the
traditional securities markets. Many major
investment banks that had dramatically curtailed or even suspended their
energy and oil trading operations are now moving heavily back into this
area. This compares to the gasping technology sector, where the hope and
enthusiasm of 2003 has disappeared into a desperate boredom.
We look for the economy to maintain its momen-
tum until monetary policy begins to bite. This
could be delayed well into 2005, when whoever is
in the White House deals with the worsening situa-
tion in Iraq. The Fed will be loath to add economic
setback to a very difficult political and military
situation. Like the Federal Reserve during the
Vietnam era, inflation fighting will take a back seat
to the war on terror and in Iraq.
Strong commodity and energy prices have been
positive for Canada. The strong Canadian resource
base, particularly the energy sector, has put a
strong bid under the Canadian dollar. This allowed
the Bank of Canada to be more modest in its tight-
ening policy, with a .25% increase in September.
The Bank of Canada has had to temper its interest
rate increases because of the rising Canadian dol-
lar, despite its fears of keeping monetary policy too
lax. The rising dollar has helped to moderate po-
tential increases in Canadian inflation, as it has
substantially lowered the costs of imported goods
which are largely priced in U.S. dollar terms. Ris-
ing U.S. dollar commodity prices have also been
moderated by the strong Canadian dollar apprecia-
tion.
Credit Market Comments
The levitating act of the bond market is a worthy
tribute to that master financial illusionist, Alan
Greenspan. While all eyes were on oil prices
reaching record highs and his monetary tightening
high wire act, the rising bond market entered from
off stage in a spectacular finale to the quarter.
It is hard to believe that the long end of the bond
market rallied over 4% in a quarter when the Fed-
eral Reserve raised interest rates twice and oil
prices hit a record $50 U.S. per barrel. Like the
financial press, one finds it hard to explain using
conventional economic and financial analysis. Be-
ing corporate bond specialists, we can be unsophis-
ticated enough to attribute the bond market.s rally
to .market spirits.. While this might seem a tad
.technical. to the reader, it surely is better than the
current vogue of market strategists and financial
reporters that rising oil prices are deflationary!
Indeed, when everyone has adopted a unanimous
view of the world, markets tend to confound by
doing the exact opposite of market expectations.
The resolve of investors is then tested by keeping
them .offside. in their portfolios and performance
until the pain of underperformance becomes un-
bearable. The turn in the market comes when
enough of them throw in the towel for the market
to reverse direction.
It seems to us that we are reaching this turning
point. A recent Wall Street Journal article was de-
voted to the discomfort of portfolio managers and
traders who called the economy and monetary pol-
icy correctly but who have had their portfolio
heads handed to them by the strong rally in bond
prices over the 3rd quarter of 2004. Many of these
intrepid souls have been forced to take their bets
off the table by organizational and career impera-
tive. Wall Street traders have massively reduced
their large short position in Treasuries and portfolio
managers have extended duration and moved back
into the now expensive mid sector or .belly. of
the bond market.
1996 to Present
The rally in Treasuries and the consequent drop in
U.S. 30 year mortgage rates led to increased Treas-
ury buying by mortgage investors. We have com-
mented in the past on this added momentum to in-
terest rate movements. The graph above shows the
higher lows and highs for bond yields since the
bottom in June 2003. It also shows the volatility
which we believe comes from mortgage hedging.
It tends to accentuate the directional movement of
interest rates, as we have seen in the recent bond
rally. It will also add to the rise in yields when
yields bottom out, as they now seem to be doing.
Scarcer money means higher yields. We look for
mid and long-term bonds to rise in yield in the
months ahead, as the reduction in money supply and higher short term interest
rates reduce the ne-cessity to invest in riskier and longer term securities.
tary policy tightening, reflecting the tension be-
tween less available money and better credit funda-
mentals. While spreads have ceased to narrow and
have begun to widen, corporate bonds still offer
additional incentive to yield starved investors. The
enthusiasm for popular new issues has continued,
although the weakness in the equity markets seems
to have spilled over some caution into the credit
markets. We think that corporate bond spreads are
very tight. Lower quality bonds do not pay suffi-
cient compensation for potential credit losses in a
weaker economy. This is a period to upgrade port-
folio quality and to watch from the sidelines.
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