Income Strategy September 22, 2006 :

There appears to be a major change in the attitude of investors toward bonds and other fixed income investments. The recent announcement by the Federal Reserve following the decision to hold interest rates at 5.25% for the second time in a row has helped to clarify that the US economy is not growing as fast as it was earlier in the year.

The Fed stated that there has been a moderation in growth which is partly a reflection of a cooling in the housing market. The Fed has left the door open for further rate changes which will be dependent on incoming economic data.   The Fed also sees inflation pressure declining as the price of energy products continue to fall most notably natural gas and gasoline which have fallen for weeks now and show no sign of leveling off yet.

The US treasury market staged the largest one day rally in over 17 months with the price of the 30 year bond moving up 16 basis points, causing the yield to fall 0.033%. Investors are becoming more convinced that the US economy will continue to slow and commodity prices will continue to moderate leading the Federal Reserve to lower rates early next year.

The yield curve in the US continues to be partially inverted for example the yield on the 2 year bond is 4.67% while the yield on the 10 year bond is only 4.59%. The inversion is even more dramatic between the 6 month T-bill at 5.01% and the 30 year bond at 4.74%. An inverted yield curve has historically forecast a recession starting 6 to 9 months later. This inversion has been in place for almost two months now and a recession could be on the horizon for early next year.

This news should reinforce the idea of extending term on bond investments as there is increasing potential for rates to fall over the next few months. Once the Federal Reserve starts to reduce interest rates they will continue until there is some concrete evidence that the economy is turning up. Be ready for rates to decline and for that decline to far longer and far further than anyone is prepared to forecast at the moment.