Treasury Talk

Michael McDonald, writing for Bloomberg is talking about What Fidelity Knows About Bernanke That Gross Doesn't.

Bill Gross, manager of the world's biggest bond fund at Pacific Investment Management Co., says Treasuries maturing in less than two years will lead a market rally next year as the Federal Reserve lowers interest rates.

George Fischer, who oversees $22 billion in debt at Fidelity Investments Inc., the world's largest mutual fund company, says short-term U.S. government debt will lose the most because the central bank, which meets this week, will keep rates unchanged, possibly through next year.

"We're at a very odd point here in bond market history," Fischer said in an interview from his Merrimack, New Hampshire office. "The Fed is being very clear that they do not want to ease soon, but the bond market is saying, 'we know better'".

“The conflict may explain why the biggest quarterly rally in four years is unraveling. Fund managers including Federated Investors say they are less convinced Fed Chairman Ben S. Bernanke will lower borrowing costs as soon as the first quarter of 2007. The latest government report showed stronger-than- anticipated job growth and a jump in consumer confidence.

“‘We're at a very odd point here in bond market history,’ Fischer said in an interview from his Merrimack, N.H., office. ‘The Fed is being very clear that they do not want to ease soon, but the bond market is saying, “we know better”’…

“Goldman Sachs Group Inc. and Merrill, two of the 22 primary dealers of U.S. government bonds that trade with the Fed, agree with Gross. They forecast the central bank will lower its target to 4% next year and that two-year notes will lead a rally. Merrill forecasts that yields on the debt will fall to 3.8%, while Goldman predicts 4.2%.

“Strategists at Lehman Brothers Holdings Inc. and RBS Greenwich Capital Inc. say Fidelity is right. There is a growing likelihood the Fed will leave the overnight rate unchanged, further erasing the advances that pushed two-year note yields to eight-month lows, they say.

“Fed Vice Chairman Donald Kohn warned investors on Oct. 4 not to underestimate the central bank's inflation concerns. He said he's more worried about a pickup in consumer prices than a slowdown in growth. ‘Further upward movements in inflation would be very adverse to the economy,’ he said…

“The decline in home prices after a five-year real estate boom will cause the economy to slow and force the Fed to lower rates to avoid a recession, McCulley wrote on Pimco's Web site on Oct. 19. ‘To think otherwise after a bubble is to not understand bubbles.’

“Gross said in an Oct. 10 interview that he is most bullish on six- to 18-month Treasuries. He boosted his holdings of Treasuries and bonds of federal agencies to 12% in September, the highest since January. His $97 billion Total Return Bond Fund has gained 2.5% this year…

“‘The market is starting to get the sense that maybe the slowdown is not going to be as severe and the Fed is not going to ease as soon,’ said Donald Ellenberger, who oversees $5.5 billion as co-head of government and mortgage-backed securities group at Federated Investors in Pittsburgh…

“Fischer is avoiding two-year notes. Instead, he is buying 10-year Treasuries and securities maturing in less than six months. His $5.2 billion Fidelity Government Income Fund, which holds at least 80% of its assets in government securities, has earned 2.16% so far this year, according to Fidelity data.

"If you must buy, buy 10 years," said Amitabh Arora, head of U.S. interest-rate strategy in New York at Lehman Brothers. "Do not buy the short end of the yield curve."

Analysis

About the only thing that is clear from the above article is that everyone is talking their book. Not only that, but the book is suspect. Let's start with a bit of reality, moving on to the ridiculous, and finally to the absurd. In all cases I am accepting the statements as presented above.

The Reality

• Bill Gross's $97 billion Total Return Bond Fund has gained 2.5 percent this year.
• Fischer's $5.2 billion Fidelity Government Income Fund has earned 2.16 percent so far this year.

Enquiring minds might be wondering how it is remotely possible for a government bond fund to only be up 2.16 to 2.5% so far this year. After all, anyone parked in 3-6 month treasuries would be up 5% annualized or so. Anyone playing longer durations that caught the market bottom in May would be up substantially more than that. Something is seriously wrong with this kind of performance when someone can do much better by buying treasuries and holding them, or simply by parking money in CDs. Short term government backed CD's are yielding 5.5% at some banks.

Could the answer be expenses and management fees? If so, exactly what performance are investors paying for? What are investors getting in return?

If one is going to pay a management fee, one might expect better management. Perhaps the problem is the nature of the funds themselves. There are short term funds, intermediate term funds, and long term funds. Exactly what is there to manage in those funds that remotely merits fees approaching 1% or even higher? After all, the investor is supposed to pick the duration correctly himself, then within a limited range, the fund manager takes as much as 25% off the top for "managing" that decision. Give me a break. How about a "managed treasury fund" that allows management discretion to do the task at hand: manage money. Is that too tough to ask?

If there was such a fund and IF the manager did the task at hand very well, perhaps that person/management team would be worth 1%. The reality of the picture is that close to 25% of the gains in these bond funds go up in smoke in management fees, with enquiring minds asking "For What?"

The Ridiculous

• According to Federated Investors "The latest government report showed stronger-than- anticipated job growth and a jump in consumer confidence."
• "Strategists at Lehman Brothers Holdings Inc. and RBS Greenwich Capital Inc. say Fidelity is right. There is a growing likelihood the Fed will leave the overnight rate unchanged, further erasing the advances that pushed two-year note yields to eight month lows".

Enquiring minds might be wondering exactly what "stronger-than- anticipated job growth" Federated Investors is talking about. Job growth this year has been extremely slow. I talked about jobs back in August in Strike Four after the fourth consecutive miss vs jobs expectations. I talked about jobs again on October 10th in A Discrepancy in Jobs? The fact of the matter is that job gains during this entire recovery have been very weak and both GDP and jobs have been tailing off this year.

Even more odd is the expectation that "A growing likelihood the Fed will leave the overnight rate unchanged, [will] further erase the advances that pushed two-year note yields to eight month lows" while not expecting the same to happen to ten-year notes. If two year treasuries get hammered it is extremely likely that ten year notes will suffer even more.

The Absurd

• "If you must buy, buy 10 years," said Amitabh Arora, head of U.S. interest-rate strategy in New York at Lehman Brothers. "Do not buy the short end of the yield curve."
• "Short-term U.S. government debt will lose the most because the central bank, which meets this week, will keep rates unchanged, possibly through next year.", said George Fischer at Fidelity.

I am simply flabbergasted at the above statements. Yes, there are reasons to buy 10 year treasury notes, but fear of being punished in six month bills is simply not on the list. The reasons to buy the long end are because the yield curve is inverted, the economy is weakening led by housing, and because of expectations of future cuts by the Fed.

Moving along, can someone tell me how it is possible that short term debt "will lose the most" if rates stay unchanged? That statement is so blatantly absurd I am wondering if it was a misquote. Yet, in context of other statements made by Fischer, it is clear he is buying 10-year Treasuries and very short term debt (under 6 months) while shying away from 6 month to 1 year timeframes. How can you lose on 6 month to 1 year durations if rates stay unchanged? All one has to do is simply roll the bills over as they mature and sit back and collect over 5% yield. If for some reason yields skyrocket, the long end of the curve (ten year and above) would likely get hammered the most. On the other hand, if treasuries put in a massive rally, the long end may gain the most, but remember the premise presented was that "the central bank will keep rates unchanged, possibly through next year".

Is this a case of talking one's book so much that a person needs to find silly statements to support it? Regardless, put me in the group with Goldman Sachs and Merrill that agrees with Pimco. I am not exactly a huge fan of McCulley, but his statements: "The decline in home prices after a five year real-estate boom will cause the economy to slow and force the Fed to lower rates to avoid a recession. To think otherwise after a bubble is to not understand bubbles." are among the few statements in the Bloomberg article that make any sense.

Now, can we just ask a bond fund to return a reasonable yield off the housing slowdown premise or is that expecting too much? After all, a simple strategy of buying six month notes and rolling them over is beating the pants off of all of those fund managers all year long. Anyone who caught the May top in yields on longer term durations is doing far better than that.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/