Fixed Income Investors Drive Interest Rates Lower

Fixed income investors are thumbing their noses at the idea that interest rates are going to move higher because of the strength of the global and U.S. economy.  Today the 10 year treasury fell by 8 basis points to close around 2.36% after hitting 2.6% last month as the Fed moved the fed funds rate higher by 25 basis points.  Logically the move to 2.6% from 1.5% in early September was an overshoot.  Investors in preferred stocks and baby bonds had driven the average price of all issues down by 4-5%  last month but have now driven prices back up by 2-3% from the lows. Certainly there is a continued hunger for yield.

Investors have to form their own conclusions as to where they believe the economy and interest rates will go in 2017 as you can be almost certain that the Fed has no real idea of where they should go–their latest forecast is for 4 rate hikes this year–we think this is not likely.  Even if they do raise rates more than we believe the marketplace will determine the level of longer term rates–i.e. the 10 year and 30 year treasuries and unless the global economy explodes higher the Fed will be simply flattening the yield curve (short term rates go higher while long term rates remain flat or move higher at a slower rate than short rates).

Here is what we think will happen during 2017.  We believe there will be at least 1 interest rate hike, with a possibility of 2.  Each of these will be 1/4%.  Our thoughts on this are driven by a few factors.  1 of these factors is energy prices.  It appears to us that both crude and natural gas prices are now likely near the top end of the range for the year.  While today a 7.1 million barrel drop in inventories was announced there are around 4,000 DUCs (drilled but uncompleted) wells that can ramp up quite fast  and the drillers are becoming exceptionally talented in coaxing more oil or gas out of every well. The oil and gas producers are getting very efficient.

2ndly we need to watch inflation.  This dovetails with energy prices above as the one item that could shock prices quickly and severely  is energy prices.  We noted above that we would be surprised if energy prices moved much high–but anything can happen.  We believe that inflation can and will move a bit higher that the current rate, but remember the inflation rate in the last 12 months is a measly 1.7% (through the end of November)–this remains below the 2% Fed target.  Anecdotally we think wages will push inflation up somewhat as wages nationwide are moving a bit higher as minimum wage hikes take effect, but inflation rates should remain modest–2.5%.

Additionally, we have to focus on interest rates around the world since money flows are global–bond buyers will go anywhere in the world to find yield and you can be certain they are not getting safe yield anywhere on the globe that is close to that of U.S. notes and bonds.  Only Greece and Portugal have 10 year notes with yields higher than the U.S. and those are hardly low risk notes.  Germany now pays 24 basis points (a basis point is 1/100th of 1 percent), France 79 basis points and the UK is at 1.29%–hardly competitive with the U.S. 10 year treasury at 2.36% today. Japan has moved away from negative rates but still pays just 10 basis points on their 10 year–hardly competitive to a yield hunter.  Now there are occasional flickers of economic hope globally, but we need more than a flicker here or there to ignite interest rates.

We have always formulated our own “forecast” (even if it is wrong we formulate our forecast to guide our investing–last year expecting 3-4 interest rate hikes we focused on short duration securities and even though we were very wrong short duration performed ok–although likely a percent below high yield perpetuals) to help us determine if we want to invest in perpetual preferreds or long duration baby bonds or if we want to stay with shorter durations.

For 2017 we will primarily focus on short/moderate duration BUT will also buy a perpetual here and there. For instance we bought the NuStar Energy LP preferred units last month.  This is a 8.5% fixed to floating rate issue for which we paid $26.05 and is now trading at $26.76.  Fixed to floating rate issues trade with less volatility than fixed rate perpetuals.  When we do buy a perpetual it will be high yield (above 8% coupon) as these will trade firmer than investment grade.  This means it will likely be a mREIT preferred or two as these are the most dominant issues available excepting the shipping sector and the shippers are for the most part very high risk.

Beyond the above we will likely move out of the 2 CEFs we own as we are poor pickers in this arena so we just as well stick to what we do best.  We also will start harvesting some profits in the Blended Income Portfolio. We will be buying some healthcare REITs where there are some values in issues such as Omega Healthcare (NYSE:OHI) which caries a 7.49% current yield.

For those wanting to peruse the fixed to floating rate sectors we have these issues here. For those looking for short/medium duration issues you can find them here.

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