Newsletter Q3 2005
July 15, 2005
The Interest Rate and Dollar Conundrums
In mid-February, Federal
Reserve Chairman Alan Greenspan expressed surprise at the low level of long-term
interest rates after the Fed had raised the fed funds rate by 1.50% since June
2004. Expecting long-term rates to rise along with short-term rates, Chairman
Greenspan referred to the subdued level of long-term rates as a “conundrum.”
Since then, the fed funds rate has increased another 0.75% to 3.25% and the
yield on the 10-year U.S. Treasury has remained virtually unchanged at 4.18%.
Doug Gillespie of Gillespie
Research Associates recently shed some light on the flatness of the yield
curve. He reviewed the data from the Federal Reserve’s Z.1 publication, “The
Flow of Funds Accounts of the United States.” During 2004, net acquisitions by
foreign investors represented 98.5% of the U.S. Treasury’s net debt issuance of
$363.5 billion. The Federal Reserve purchased an additional $51.2 billion of
U.S. Treasury debt for its own portfolio. Thus, the combined net purchases by
the Fed and foreign investors represented 112.6% of U.S. Treasury debt net
issuance. Strong demand of this magnitude accounts for the decline in long-term
interest rates on U.S. Treasury debt.
According to the Treasury
survey of the fifteen largest foreign U.S. Treasury debtholders, there was a
shift in demand during the first quarter of 2005. Net purchases by foreign
central banks amounted to $36.1 billion. The two largest holders of U.S.
Treasury debt, Japan and China, together reduced holdings by $9.3 billion. The
diminished demand by foreign central banks was offset by a significant increase
in demand by Caribbean banking centers. Their holdings nearly doubled during
the quarter, increasing by $65.8 billion to $137.2 billion. It is not clear who
is behind the purchases from the Caribbean banks, but the banks are often used
by offshore hedge funds.
Stephen Roach, economist at
Morgan Stanley, recently offered his assessment on Bloomberg Television of the
U.S. currency and its reliance on foreign creditors:
The dollar call is a very, very tricky one.
This is the fourth up-trade in a three-year plus downtrend in the dollar. And
like the other three, I think this one will be short lived. I think the big
call on the dollar, given our current account deficit, is down, down, down. And
once global investors, whether they are central banks or private portfolio
investors, perceive this ongoing currency risk they will demand to be
compensated for taking that risk and push U.S. rates higher.
The pressure on China to
revalue their currency continues. China’s trade surplus expanded in June 2005
to $9.7 billion, compared to $1.6 billion in June 2004. Exports increased by
30.6% from a year earlier while imports increased by 15.1%. As the $18.5
billion cash buyout offer for Unocal by CNOOC suggests, China will probably
attempt to reduce their U.S. dollar reserves by buying scarce resources before
they revalue the yuan and reduce the value of their remaining U.S. dollar
holdings.
Stephen Roach also offered
his opinion regarding Federal Reserve policy and the U.S. current account
deficit:
What’s the Fed doing? They’ve got the funds
rate up to 3% (now 3.25% as of June 30). The forward-looking inflationary
expectations from the University of Michigan is 3%. The (real rate adjusted for
inflation) funds rate is zero. Don’t give the Fed all this credit. They have
taken rates from negative to zero… The degree of liquidity that the Federal
Reserve Board is injecting into the U.S. and global economy right now with its
unconscionably accommodative monetary policy is a very dangerous long-term
development… We need a guy like Paul Volcker at the Fed who’s not afraid to put
the real interest rate to a level that deals with the excesses of U.S. financial
markets and the economy… I would like the Fed to get real on the real federal
funds rate and take it to a level that helps us deal with our biggest imbalance
we’ve ever had, this massive record current-account deficit. This is an
unconscionable excess in the U.S. for a central bank to pretend is not a
problem.
I’m in total agreement with
Stephen Roach on the subject of Federal Reserve policy.
Additions
Two closed-end funds,
Aberdeen Asia Pacific Income Fund (FAX) and First Trust/Aberdeen Global
Opportunity Fund (FAM) were purchased for selected accounts. FAX invests
primarily in government bonds of Australia, South Korea, Thailand, Singapore,
Malaysia, and the Philippines. FAM invests predominantly in bonds denominated
in foreign currencies and is broadly diversified among many countries. FAX
currently has a yield of 6.7% and sells at a 3% discount to net asset value.
FAM currently has a yield of 8.6% and sells at a 5% discount to net asset value.
The Alliance World Dollar
Government Fund II (AWF) was purchased for some accounts. AWF is a closed-end
fund that invests in U.S. dollar-denominated bonds of foreign countries. The
largest holdings are in Mexico, Brazil, and Russia. The fund currently has a
yield of 7.2% and sells at a 12% discount to net asset value.
The MFS Charter Income
Trust (MCR) was purchased for some retirement accounts. MCR is a multi-sector
closed-end fund that invests in bonds of the U.S. Government and Agencies, U.S.
and foreign corporations, and foreign governments. 32% of the portfolio is
invested in foreign countries but 98% of the portfolio holdings are denominated
in U.S. dollars. MCR currently has a yield of 6.0% and sells at a 10% discount
to net asset value.
The Insured Municipal
Income Trust (PIF) and Investment Grade Municipal Income Trust (PPM) were
purchased for some taxable accounts. The credit quality of both funds is high
and both funds have relatively short weighted average durations of about 4.5
years. Both funds are leveraged (40% of assets) with preferred stock issues
which pay low adjustable rates. PIF currently has a tax-exempt yield of 5.0%
and sells at a 14% discount to net asset value. PPM currently has a tax-exempt
yield of 5.5% and sells at a 14% discount to net asset value.
U.S. Treasury bills were
purchased for many accounts as an alternative to money market funds. The
Federal Reserve appears determined to continue raising short-term rates. I
expect U.S. long-term rates to rise from present levels and have shortened the
average maturity of fixed income portfolio holdings.
Deletions
Positions in Holly
Corporation (HOC) were reduced. Due to the stock price appreciation, positions
had become overweighted relative to potential further appreciation.
Some higher cost tax lots
of UT Starcom (UTSI) were sold in taxable accounts. The realized tax loss will
offset realized gains from other securities.
Some larger positions in
Canadian Government bonds were reduced. Interest rates on Canadian Government
bonds have declined and are now lower than U.S. Treasury bonds. There also
appears to be some political pressure developing to increase government
spending.
Positions in the American
Century International Bond Fund (BEGBX) were reduced. The fund consists
primarily of euro-denominated bonds. Bond yields in Europe have declined and
the euro is somewhat expensive relative to the U.S. dollar on a purchasing power
parity basis. The proceeds will be used to invest in other countries that offer
higher yields and more potential for currency appreciation.
The Salomon Brothers
Municipal Partners Fund (MNP) was sold. MNP sold at an 8.5% discount to net
asset value. Although the yield is high at 6.0%, the dividend rate is likely to
be reduced. Proceeds will be used for other tax-exempt funds that sell at
larger discounts and have shorter weighted average durations.
If you have any questions
regarding your accounts, please do not hesitate to call me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA
Sabino
Investment Management, L.L.C.