It’s a new year, and for newsletter writers and portfolio managers it means the bar has been reset. It’s time to put on our thinking caps and make grandiose predictions for the year to come. After watching CNBC for three days last week, I found it remarkable how much of a consensus has formed for 2010. There seems to be such an aligned consensus that we can already see the new trends forming in December as hedge funds and portfolio managers put their money where their mouth is. 2010 will be a key year for the U.S. dollar and U.S. bonds.
Will the Federal Reserve Bank raise short term rates in 2010? The consensus is moving from early 2011 to mid-year 2010. The reason for this has been stronger economic data over the past month with better results in unemployment claims, the Chicago PMI, Case-Shiller, employment, and consumer spending. Bond investors are already reacting to the change in interest rate expectations by selling long term bonds and driving long term interest rates higher. As bond investors help raise interest rates with their selling, they’re forcing the yield curve to steepen while short term rates are kept artificially low. Eventually, the Federal Reserve will have to react to rising long term rates and positive economic data by raising the Fed Funds Rate.
"A sharply upward sloping, or steep yield curve, has often preceded an economic upturn. The assumption behind a steep yield curve is interest rates will begin to rise significantly in the future. Investors demand more yield as maturity extends if they expect rapid economic growth because of the associated risks of higher inflation and higher interest rates, which can both hurt bond returns. When inflation is rising, the Federal Reserve will often raise interest rates to fight inflation."1
The U.S. dollar will struggle between two powerful forces in 2010: (1) stronger economic data (bullish) and (2) a year ahead of sizeable debt offerings from the U.S. Treasury (bearish). The U.S. dollar is rallying as a result of those economic readings in December in addition to being long overdue technically on the charts. If leading, coincident, and lagged economic indicators continue to improve in 2010, it will serve as support for the U.S. dollar. The bearish forces looming over the dollar are coming from issuance risk. "Primary dealer Morgan Stanley expects the Treasury to sell $2.6 trillion in fiscal 2010, which began in October. That’s a 40% increase year-over-year."2 This isn’t a problem as long as we have ample bids to cover the treasury auctions, but recent events show that there has been a drastic decline. The last 30-year bond auction was held on December 10. The bid-to-cover ratio was 2.45. This means there were 2.45 times the dollar volume of bids versus the volume of Treasuries sold. At 2.45, that’s much lower than the recent peak of 2.92. We can see the same thing in the 10-year auction in which the bid-to-cover ratio has fallen from a peak of 3.28 to 2.62 on December 9th. Additionally, indirect bidders (consisting of foreign central banks) have lowered their percentage participation in the auctions from 50% in July to 40% in December for the 30-year bond auctions and from 55% in September to 35% recently in the 10-year bond auctions.
How does one invest with such an outlook as this for the dollar and interest rates? Let’s go over a few intermarket points first:
- The U.S. dollar trends inversely to commodities
- Commodities rise with interest rates due to inflation expectations, while bond prices fall
- Falling bond prices are normally bad for stocks near economic cyclical peaks
- We are currently in an economic recovery
- High interest rates support the dollar while low interest rates do not
Predicated on continued economic recovery, and given the current interest rate environment, commodities and stocks should continue to perform while bonds should underperform. Concerning stocks, I believe mid to late-cycle sectors such as industrials and energy should do well. Where else can an investor find high dividend yields and low P/E multiples but in energy stocks? Technology tends to do well at the beginning stage of a recovery (2009) and market performs in the midst of a recovery.
Any bond portfolio will want to hedge against interest rate risk through various open or closed mutual funds that aim to achieve that objective. Even in the bond asset class, corporate bonds should outperform most bond metrics due to the economic recovery.
Concerning commodities, I’ve turned from bullish to neutral on precious metals based on a rally in the dollar. On the other side of the commodity spectrum, I think the outlook for basic materials and energy should continue to perform as the economy improves. While the dollar rallied in December, precious metals fell while energy and basic materials held their ground. I think 2010 will be much of the same barring any new financial, economic, or political crisis that could spark a flight towards gold.
The financial markets act as a discounting mechanism. They are currently telling us that we are in the midst of an economic recovery with the stock and commodity rally we saw in 2009 along with the current steep yield curve. Price to earnings multiples have expanded without the accompanying rise in earnings. 2010 will be a year for earnings to catch up to price (underlined for emphasis). If earnings do not catch up, well then Houston, we’ve got a problem. The financial markets are also telling us that we may have seen a trough in interest rates as the Federal Reserve Bank begins to remove its overly accommodative monetary policy in 2010. The change in monetary policy will likely cap any substantial chance the stock market has to continue its trend much higher. 2010 looks to be a range-bounded market much like we saw in 2004. Additionally, higher rates will not help the housing market that got us into this mess in the first place as a significant portion of adjustable rate mortgages reset in 2010. It will be interesting to see in 2010 just how much accommodation the Federal Reserve Bank will remove from its mortgage-backed security purchases as bond investors drive rates higher.
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1 Bond Basics. PIMCO. June 2006
2 Levine, Deborah. Treasury yields to rise in 2010, dealers say. Market Watch, December 30, 2009 (accessed January 4, 2010).
