Bond Outlook October 5th

For many weeks we have been struggling with the likely development of the US yield curve, and consequently with our recommendation for maturities for USD fixed-income portfolios. Since the end of April 2005, our recommendation has been to "barbell" between floaters and 10 year maturities. This has proven a sound strategy, but, as regular readers will have noted, we have become increasingly uneasy about how long the strategy can remain appropriate. This is because we believe the USD 10 year yield to be vulnerable to a serious break out to higher levels. Consider the following:

• The Fed is determined to continue raising rates to a "normal" level of 1% or so above nominal GDP growth. That suggests 4.25 or 4.5% before tightening is discontinued
• An announced objective of Greenspan before his retirement is to slow down (if not deflate) the housing bubble, clearly identified as the source of negative saving and over-spending of US households. Thus Greenspan wants a higher 10 year yield.
• The Chinese on the other hand are deliberately using their capital flow in the USA, not just to keep the dollar firm, but also to keep long-term yields low, as they are currently following a policy of encouraging Americans to spend more than they earn.