March 3, 2005 -- Excessive liquidity will persist in the U.S. credit market for roughly the next three years, predicted Dan Fuss, chairman of Boston-based investment firm Loomis Sayles, at a New York press conference yesterday. That's about the time it will take the economy to recover from the "capital-goods-led" recession in 2000. When that recovery is complete, Fuss expects interest rates, which bottomed out in June 2003, to shoot up as government and corporations "slug it out for money."
With the U.S. military currently still at war in Iraq, Fuss expects the government to likely continue issuing more debt, while the Fed proceeds slowly with its tightening policy . "I think the central bank is so sensitive to keeping the markets moving that they will continue to follow... this moderate approach and gradually reduce the leverage in the financial markets," he said.
The resulting liquidity has pushed up the price of bond assets, while yields keep shrinking. Fuss pointed out that the interest rate spread between two- and ten-year Treasuries is now about a hundred basis points, down from 250 basis points in 2003. "And unless you think Alan Greenspan and his friends are kidding, it's going to continue to come down," he said of the spread. Ultimately, Fuss sees the Fed funds rate rising to 3.75% for the short term; the 10-Year Note rising to 5.25%, and the 30-Year bond rising to 6.25%.
Fuss thinks that credit trends in most areas of the corporate bond market will be "very good" for the next four years. The exception would be in recent issues of high-yield debt with weak credit outlooks. These issues "have come to market because of the push for yield," he said. "I think they'll have a very high default rate."
Fuss also sees the eventual competition for funds between corporations and the government as beneficial for existing industrial companies because it will "prohibit the expansion of capacity." Here, Fuss may have been hinting of a possible bear market in high-yield bonds somewhere down the road, as high borrowing costs choke off demand from new entrants, who are, by definition, high-yield borrowers.
From an international perspective, David Rolley, head of Loomis's global fixed-income group, said "yields are low and spreads are tight. What's a bond manager to do?" His ready answer: look to markets whose central banks have already tightened rates over a longer period to obtain higher interest rates than are available domestically. Regions where housing booms have reached a peak are especially attractive -- like Australia and New Zealand. Once boom turns to bust, government policies undertaken to protect growth, such as lowered rates, support bond prices and thus provide capital gains for bondholders.
Rolley described himself as a "dollar bear" who sees markets generally as "probably closer to the bottom than the top of the dollar bear market." Looking for other currencies that will benefit from the dollar's continued drop, the Asian Rim markets -- China in particular -- are promising candidates, he said, despite China's erratic progress toward a market economy.
As an example of progress, Rolley cited recent measures by China's State Administration of Foreign Exchange de-control capital assets. Another example was China's encouragement of the World Bank and the Asian Development Bank to issue bonds in local renminbi currency. This step would further modernize the nation's financial system -- especially if the bonds were made available to foreign as well as domestic investors.
"So there is encouragement for the development of a deeper Chinese fixed-income bond market," Rolley concluded. "One of these days when we talk about bonds, we're going to not just be talking about the Big Three [U.S., Japan, Western Europe] -- we'll be talking about the Big Four."
Contact Bob Keane with questions or comments at:firstname.lastname@example.org.