Mostly Smooth Sailing with Occasional Choppy Waters
Executive Summary
As 2006 drew to a close, corporate cash investors found themselves in a surprisingly benign market. Despite the 100 basis-point increase in the Fed funds rate, major short-duration bond indices brought in positive returns almost universally.
As managers of corporate cash investments, we picked five trends that reflect what we feel may have the greatest impact on high-grade, short-duration, and buy-and-hold traditional corporate cash investment accounts.
The five trends to watch are:
- Economy and Interest Rates: Respectable with Range Bound Rates
- Corporate Credit: Fundamentally Healthy but Bondholders Beware
- Technical Factors: Positive with Plenty of Support
- Asset-backed Credit: Weakening but Still a Safe Haven
- Return Expectations: Decent but Less Satiable
Introduction
As 2006 drew to a close, corporate cash investors found themselves in a surprisingly benign market. Despite the 100 basis-point increase in the Fed funds rate, major short-duration bond indices brought in positive returns almost universally. The strong Treasury yield curve rally after the Fed went on hold in June and the tightening of corporate yield spreads to Treasury securities were two of the main drivers behind a successful year for cash investors.
In our observation of the outlooks for 2007, market strategists seem to have a difficult time agreeing with each other. Is the economy slipping into recession or picking up the pace? Will inflation or disinflation confront the Fed going into the new year? Is the 10-year Treasury note yield going to 6% or 4% or even lower? Will corporate America continue its double-digit earnings growth? Is private equity friend or foe of bond investors?
As managers of cash investments, we find that many of the debates are of little relevance to our core constituents. We chose to pick the five trends that represent our understanding of what may exert the greatest impact on the mostly high-grade, short-duration, and buy-and-hold traditional corporate cash investment accounts.
Economy and Interest Rates: Respectable with Range Bound Rates
Looking back at the trajectory of real GDP growth for the past three quarters, it is safe to assume that the economy is losing some momentum. On the other hand, the substantial cooling of the housing market does not appear to spill over to other sectors. As a result, we think growth will likely remain at a pace to be somewhat below the economy’s long-run potential, averaging just below 2% annualized between the fourth quarter of 2006 and the second quarter of 2007. The risk of recession is not zero, but the possibility is remote. Recent inflation statistics seem to suggest that core inflation will likely fall within or slightly above the perceived Fed comfort zone of a 1-2% annualized rate over the same period.
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