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Economics: Air Pocket?
New York: July 04, 2005
By John R. Stephenson

This past week, the U.S. Federal Reserve did as expected - they raised interest rates. The current hike to 3.25% was the ninth consecutive time that the central bank in the U.S. has raised the short-term interest rate and yet, a conundrum remains - long-term (10- year) interest rates are falling rather than rising. Normally, as the Federal Reserve adjusts the short-term interest rates upward, the market makes a similar upward adjustment to the rate charged for longer-term borrowing, but not this time. While lower interest rates are good news for homeowners, they may well spell trouble for the economy and financial stocks in particular.

But why the disconnect? Why are short-term rates rising and yet longer-term interest rates falling or, at the very least, staying put? The answer seems to lie in the investor's desperate attempts to obtain yield wherever he/she can find it. With the days of heady equity returns in the rearview mirror, fund managers have looked to bonds (fixed income instruments) to supply the juice for their sagging investment portfolios. This trend toward greater investment in government and corporate bonds has only been enhanced by the accommodative stance of central banks around the world that have kept real short-term interest rates at or near zero for the last several years. Not only have government bonds been the beneficiary of this speculative flow, but so have riskier fixed income asset classes such as junk bonds, emerging-market debt and structured credit products.

Further exasperating this flow of funds (driving the prices for fixed income instruments up and yields down) into bonds, has been a perceived slowdown in the rate of global economic growth. With a possible slowing of the Chinese economy in the face of rising oil prices and a protectionist West, investors have good reason to worry about the sustainability of the current economic expansion. As well, an increasingly competitive world economy with trade now occurring in both manufactured goods and services, has served to keep a lid on inflation. Both low inflation and slowing economic activity serve to keep interest rates low and act as a damper for equity prices. For investors looking to meet the imperative of an aging demographic, the relative security of U.S. government bonds and certain yield have offset the paltry returns. For now, a low interest rate low-yield regime seems to be the order of the day.

But how long can this last? As with all forms of momentum-driven buying, there is a tendency to go too far only to have a nasty correction. Of course, one catalyst for a hasty retreat from bonds might be the huge current account deficit (exports minus imports) that the U.S. has racked up. With the U.S. current account deficit requiring some $3 billion of capital inflows each and every day and the U.S. dollar, until this year, on a three year slide, one wonders how long our creditors will go before they demand more for holding our treasury bonds. With most of our proliferate ways being financed by Asian governments whose investment portfolios are dominated by dollars, is it not just a matter of time until they demand more reasonable (higher) interest rates for the portfolio risk of holding too many dollars?

Perhaps. But, in the meantime, lower interest rates, whatever the cause, have been a boon to the indebted U.S. consumer who has continued to pour money into the housing market. So much so, that the so-called "irrational exuberance" appears to have taken hold in the property market. The L.A. Times recently reported that local homeowners expect to see housing prices rise by some 22% annually for the next ten years. The National Association of Realtors reports that fully 23% of the homes purchased nationwide were for investment (speculative) purchases. It seems as if homeowners believe that property speculation is a "can't lose" proposition.

But, unlike the bubble that formed in equities during the stock market run-up of the 1990s, the housing bubble has been built on a mountain of debt. To date, homeowners have managed to dodge the rising interest rate bullet and instead of counting their lucky stars, they continue to lever up in the hope of even greater riches around the corner. With more and more renters becoming homeowners, the bottom has fallen out of the rental market. The result? In some markets, the rents have been falling as fast as house prices have been rising. But how long can it last? At least as long as it takes for interest rates to start ratcheting up. The end, when it does occur, is likely to be nasty, as low interest rates have made fools of us all.

But it isn't just the housing markets where the interest rate conundrum has been sending a mixed signal - the financial service sector is one that investors need to keep an eye on. The U.S. consumer has received this message from the policy makers in Washington over the last several years. Spend and spend some more. And banks have been as accommodating as they possibly could - in many cases, extending credit to those who in previous cycles they wouldn't touch. To date, their strategy has worked well with delinquency rates remaining low. But, if interest rates rise, then delinquency rates could skyrocket sending bank earnings on a downward spiral. Without doubt, the financial sector is the most interest rate sensitive sector (negative 70% correlation with interest rates) of all sectors of the S&P 500 index. In short, rising interest rates are bad news for financial companies. But the financial service sector represents some 20 % by market cap (the largest single sector) of the S&P 500 meaning that a slowdown in the financial sector of the market could harm even more passive equity investors such as indexers.

Investors who are looking to play a little stronger defense in their investment portfolio should consider investing in areas which are somewhat less sensitive to interest rates. A core defensive portfolio that we would recommend would focus on noncyclical sectors such as health care, consumer staples and utilities for the time being. As always, it is a good idea to take advantage of this low interest rate environment to consolidate debt to the vendor charging the lowest interest rate and to reduce, wherever possible, your overall level of indebtedness.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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