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:: October 2003 | Page 2
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BONDS
Bonds have been anything but boring during the past two
years. Interest rates have been in a generally declining
trend since 1982. As measured by the yield on
the ten-year U.S. Treasury note, a multi-decade low was recorded
this summer at 3.11%. This level coincided with the
Federal Reserve authorities voicing concerns about deflation,
implying strongly that they would do whatever is necessary
to avoid the problem including the purchase of Treasury securities
on the open market. Subsequent developments eroded
the over-enthusiasm of bond investors as stronger economic
numbers lessened the threat of deflation. Interest
rates on the ten-year note rebounded to 4.6% in one of the
sharpest moves in memory. Currently, the note is yielding
about 4%; interest rates remain near historic lows.
Federal Reserve spokesmen have repeatedly stated that there
is no reason for them to raise rates for a considerable period,
but history would suggest that an uptrend in rates is more
likely than a decline within the next year or so. This
outlook would steer investors to place their fixed income
assets in shorter maturities, under five years, rather than
locking in low rates for longer periods.
One of the driving forces holding down interest rates this
year has been the large persistent purchases of U.S. government
securities by the central banks of China and Japan. The
transition to a global economy has had a significant and
possibly worrisome impact on investment markets. The
quantity of goods imported from China has soared in recent
years with their value far exceeding the value of goods and
services imported from the U.S. China thus ends up
with a huge sum of U.S. dollars, which they have invested
in U.S. Treasury securities. Their purchases have
helped keep interest rates lower than they would otherwise
have been. Japan has been feeling the competition
from China, which has much lower labor costs. The
Japanese central bank has been selling yen and buying U.S.
dollars which they invest in U.S. Treasuries absorbing more
of the supply. U.S. consumers get inexpensive goods
from the Asian countries, which obligingly recycle the money
into our government securities.
Toward the end of September, at the urging of U.S. Treasury
Secretary Snow, an international agreement was reached to
allow the value of world currencies, excluding China, to
trade at levels determined by the market rather than have
them held at an artificial level as Japan had been doing.
The administration's goal (some would say political goal)
was to allow the value of the dollar to drop, making U.S.
goods more attractive and imports more expensive. The
manufacturing sector in this country has been rapidly losing
jobs, and encouraging a decline in the dollar is one of the
last options available to provide further stimulus to the
economy, but it is a risky one. Foreigners are owners
of a large amount of U.S. government and agency securities
(36% of U.S. Treasuries outstanding), and as noted above
their purchases have helped hold down interest rates with
a positive impact on the economy.
If, for example, a Japanese investor came to fear that the
value of the dollar would drop significantly versus the yen,
the value of his holdings translated into yen would fall,
more than offsetting the meager amount of interest earned.
He would likely stop buying, and could sell the securities
he already owns. Under such a scenario, U.S. interest rates
would need to rise substantially to induce foreigners to
purchase our securities, which, in turn, would put the brakes
on the economic recovery. Investors have yet to fully
discount this possibility, and, at the same time, the projected
rise in business activity would tend to push interest rates
up in competition with the government's need to borrow to
fund a $500 billion anticipated budget deficit. The
impact on both stocks and bonds would be unpleasant to say
the least, which leads us to lean to the side of caution
in this environment.
Your thoughts and comments are always welcome.
Sincerely,
John L. Simpson
Senior Vice President, Chief Investment Officer
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