Bonds

In March, the fixed income markets were a mixed bag. Short term rates fell 25 basis points and 90 day bills ended the month well below 6% (5.74%). Junk bonds extended their sharp February rally. Outside of short term rates and junk bonds, the fixed income markets recorded little net change in March.

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This month, the Conventional Asset Allocation Model has added to its holdings of German government bunds, taking them up to 18% of the model’s assets. Normally this would be a subject for this publication’s “Foreign Investments” section. However, the considerations involved in making this investment decision should be of broader client interest.

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The bond market continued to advance in early February. It peaked however on February 8th, the day after the Treasury completed its financing. In the week following, T-bonds held in a narrow range, but began losing ground in the last half of the month. In the final days of February and on the first trading day of March, the decline picked up momentum.

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War, recession, falling oil prices and other good inflation news combined to support the U.S. fixed income markets in January.

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In November, recession evidence continued to build. War fears started to fade. November 17 came and went, and the Bush hawk began his molt. The dollar stabilized, at least momentarily. Inflation fears faded, as oil prices traded down. In this environment, the bond market marched steadily upward all month.

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Crude prices fell 11% in October and almost all other commodities moved lower, easing recent inflation fears. The economic numbers mostly continued to say recession, with the exception of the new GNP number. However, very few believe the accuracy of the number.

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The recent improvement in the bond market is probably not the result of the politicians’ weak kneed program to deal with the deficit. Rather, it more likely stems from the lack of bad news from the Middle East and growing evidence that the economy is in a recession.

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As things heated up in the desert, the bond market swooned. Late in August, Middle East tensions eased somewhat, with the dollar and the bond market staging a rally, trimming the losses for the month. Nevertheless, bond market damage in August was still severe.

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All things considered, the bond market held up well in July. And even though the dollar index slid about 4%, there was little progress on the deficit front and inflation fears rose with oil prices. These bond market negatives were offset by increasing evidence of a recession in the works.

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George Bush turned the bond market around during the last week in June, mentioning that “tax revenue increases” are needed. Long bonds rejoiced by moving up about two points in the last four trading days of June.

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The bond market surged upward in the first part of May, and then consolidated those gains for the remainder of the month. Bonds have again blasted upward here on the first day of June.

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So far in 1990, the two markets have moved very much in tandem, at least in terms of direction. Has the bond market been keying on the stock market or has the stock market been keying on the bond market?

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In mid-April, the bond market broke sharply, stabilizing late in the month. The decline brought T-bonds down into the upper ranges of our buying zone (9%-10%). But in the first days of May they have rallied to 8.90%.

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The bond market has weathered some recent storms better than anticipated. The dollar has also performed better than expected. But inflation fears could increase in coming months.

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It was all downhill for bonds in January.

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Remember the basics: A slowing economy should bring lower interest rates but it also typically brings declining earnings, not usually a good environment for stocks.

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I continue to believe that at least a mild recession is in the cards for 1990 and that the deficit will soon start to expand. However, I no longer think this will be a strong negative in terms of bond market psychology, at least not over the next six months or so.

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Inflation continues to cool and the economy is providing more evidence of slowing, but we still have our reservations about the bond market and remain cautious.

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A lackluster T-bond rally in the first half of September seemed to be primarily a flee to quality as junk bonds were trashed. Then in the last week or so T-bonds have moved lower, even as the junk market stabilized.

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