By: Ronald D. Struck                                                               June 16, 1998

SHORT-TERM SECURITIES MANAGEMENT STRATEGY

The trend of interest rates is down and, because the rally is not based on the U.S. economy but on international money flows and markets, the Fed won’t be able to raise rates in the near future.

The Asian turmoil only aggravated a Japanese economy that was already suffering from a real-estate collapse, bad lending, nervous consumers, rising joblessness, bankruptcies, and a paralyzed leadership.  Even though the Japanese central bank has over $200 billion in dollar reserves, their $20 billion effort to stabilize the yen in April failed.  Within Japan, business and consumer sentiment has turned negative.  Around the world, investment sentiment concerning Japan has turned extremely negative, against the economy, the stock market, and the value of the currency.

At a time when stock markets around the world are trading at very high multiples of earnings, it’s bullish sentiment that matters.  It took only a swoon in the Hang Seng Index in Hong Kong last October to trigger a sharp fall in many world stock markets.  If the same happens in Japan the immediate impact on Asia will be substantial, and the U.S. will not be able to avoid the repercussions.  As a result, interest rates will move too much lower levels, particularly in the short end of the curve.  

Like longer-term securities, yields on short-term securities are tied to expectations about market conditions.  However, because of Fed actions, yields on short-term securities, such as two-year and five-year notes, have not declined like those for longer-term bonds.  Nonetheless, the Fed is running out of room to maneuver and recently the two-year and five-year notes joined the rally in longer-term bonds.  However, they still carry yields above those achieved in January and have much more room to rally than longer-term securities.

There is a scenario that I believe has a very good likelihood of occurring.  The U.S. has not yet felt the full impact of the weakness in Asia, but it will.  As this occurs, U.S. consumer sentiment will turn negative and the U.S. economy will slow down.  The Fed will become more accommodating and yields for short-term securities will decline, perhaps rapidly.  We will then see a yield curve more akin to the one that existed in 1992 –93, when the ten-year T-Bond traded at today’s levels and the two-year traded at less than 4.0% (I don’t think we will get that low).

What is the manager of a short-term investment portfolio to do?  With the rally in long-term bonds and a flat yield curve, most 90-day investment pools worth their salt are yielding more than a 30-year T-Bond.  And, you don’t get paid anything for extending maturities from one to five years.  Therefore, it is easy to make a decision not to extend maturities, maybe too easy.  If you agree that the scenario I laid out in the preceding paragraph may be likely, and you have money that could be invested in two to five year maturities but delay in doing so, you could end up leaving a lot of money on the table.

I believe managers of short-term investment portfolios should develop a strategy to quickly extend out the curve in the longest maturities they can safely accommodate.

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