PRUDENTIAL FIXED INCOME MANAGEMENT

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1 PRUDENTIAL FIXED INCOME MANAGEMENT Economic Recovery: No Death Knell for Bonds October 9 Robert S. Tipp, CFA Managing Director and Chief Investment Strategist Prudential Fixed Income Management The Economic Recovery Has Begun It s all but official. Global economic recovery is now underway. Improvements in leading indicators have finally translated into economic growth, helped by a deluge of policy stimulus. Consumers responded enthusiastically to the Government s cash-for-clunkers program, manufacturing has picked up from rock-bottom levels, and even the housing market -- the lightning rod for the recession has improved. Indeed, Fed Chairman Bernanke noted in mid- September that the US recession was likely over. At last, it appears as if the longawaited green shoots have indeed appeared. Economic Recovery = Death Knell for Bonds? We d Say No, or at Least, Not Yet While economic recoveries are typically expected to deliver all sorts of unwelcome problems to bond investors inflationary pressures, rising interest rates the early stages of these recoveries are often quite positive. Spreads of credit-related asset-backed, corporate, high yield, and emerging markets securities, which typically widen in economic contractions, tend to narrow as the economy troughs and then begins to improve, boosting performance of these sectors. Perhaps more surprising, however, is that overall bond market returns are often supported by declining Treasury yields during the early stages of the recovery cycle. In this paper, we enumerate four reasons for this seeming paradox of declining Treasury rates during this economic recovery. Economic Perspectives For more information contact: Miguel Thames Prudential Investment Management Gateway Center, th Floor Newark, NJ miguel.thames@prudential.com Reason #1: Long-Term Rates Have Already Risen Once bond investors think they ve seen the last interest rate cut during a recessionary cycle, regardless of how bleak things may be on the economic front, there is often a steep sell-off in the Treasury market that pushes up long-term interest rates significantly. Perhaps ironically, these premature sell-offs position Treasuries, and for that matter, the entire bond market, to perform well right through the early stages of economic recovery. This certainly appears to be the case in this cycle, where, within days of the Fed s final interest rate cut in December, 3-year Treasury yields began to climb. From their mid-december cycle lows of roughly.5% they began rising, eventually reaching as high as.5% this June -- a spectacular rise, indeed! With cooler heads now prevailing, 3-year Treasury yields have declined back to around.3% (at the time of this writing in mid-october 9.) And while.3% may not seem like a particularly high yield, particularly since 3-year Treasury yields often topped 5% over the past decade, it is actually surprisingly close to the ten-year historical average of.95%.

2 3-Year US Treasury Yields Have Risen +1 Bps from Their December Lows January 1, 1999 October 1, 9 % Jan-99 Jan- Jan-1 Jan- Jan-3 Jan- Jan-5 Jan- 3-Yr US Tsy Yields Reason #: Long-Term Rates are High Relative to Economic Growth Jan-7 Jan- Jan-9 1-Yr Avg:.95% +1 bps The second reason is that current long-term rates are high relative to the level of growth and inflation the US economy is currently experiencing. This is shown in the graphs below, which compare nominal economic growth (economic growth plus inflation) with the yield on the 1-year Treasury bond. The top graph plots the two indicators separately, while the bottom graph plots the difference, or spread, between the two indicators: % YOY Dec-79 Dec-1 1-Year US Treasury Yields vs. Nominal GDP Growth December 31, 1979 June 3, 9 Dec-3 Dec-5 Dec-7 Dec-9 Dec-91 Dec-93 Dec-95 1-Year US Tsy Yields Treasury yields often fall Dec-97 Dec-99 Dec-1 Dec-3 Nominal GDP Dec-5 Dec % -.% % YOY 1 1-Year US Treasury Yields Less Nominal GDP Growth December 31, 1979 June 3, Yr US Tsy Yields Less Nominal GDP when the gap between Treasury yields and nominal GDP is high +5.9% - - Dec-79 Dec-1 Dec-3 Dec-5 Dec-7 Dec-9 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-1 Dec-3 Dec-5 Dec-7 Source of Charts: Bloomberg.

3 As the graph illustrates, the current interest rate cycle closely resembles the pattern of the last two recessions, where interest rates rose rapidly as the economy bottomed, leaving interest rates untenably high relative to belowtrend economic growth. This cycle appears to be no different. The spread is extreme at present, and we expect it to narrow in coming months and begin approaching historical averages. While most of the narrowing may come from economic growth rising from their historic low levels, some of it is likely to come from US Treasury yields falling. Music to bond investor ears: declining US Treasury yields usually pull down yields, and push up prices and returns, across all fixed income sectors, which trade off of their spreads to US Treasuries. Reason #3: Combination of High Money Fund Assets + Low Money Market Rates = Positive Flows into Bonds Should Continue The stressful markets of spurred an exodus from long term assets, both stocks and bonds, into short-term money funds. As the financial crisis brewed, assets began pouring into money funds, with money fund levels reaching all time historic highs of $3.9 trillion in January of 9, as shown in the graph below. You can see how this influx dwarfed the last exodus out of stocks and into money funds, which followed the popping of the Internet bubble back in. $ trillions Level of Money Fund Assets March, 199 September 3, 9 Internet bubble bursts A high of $3.9 trillion on 1/1/9 Money Fund Assets As market volatility began to wane this year, however, this cycle began to reverse. Although record amounts of assets have left zero-yielding money funds in search of higher returns, those assets represent only a fraction of the assets that came in. In other words, there are hundreds of billions to go before money market fund levels recede back to pre-crisis levels. Unlike past cycles, these asset flows have moved disproportionately into fixed income, rather than stocks. Stung twice in the past decade in the stock market, investors apparently are gravitating towards fixed income s promise of stable yields rather than the prospect of high returns in stocks. Furthermore, the motivation for these flows increased yield and return is likely to be with us for some time. With the myriad headwinds now facing the US economy, including high unemployment and downward pressures on wages and real estate prices, the Fed is likely to be on hold well into 1, keeping money market rates near zero. As a result, the huge reservoir of money fund assets is likely to continue to pour into long term fixed income in search of higher yields for some time. Reason #: Institutional Pension Fund Demand for Long-Term Fixed Income Corporate pension funds and baby boomers have become, and are likely to remain, a steady source of demand for long term bonds for some time into the future. As has been well-documented, the enactment of the Pension Protection Act of has prompted corporations to both increase their fixed income allocations, and extend the 3

4 durations of their bond portfolios to more closely match their pension liabilities. While it is unclear exactly how far along we are in this process, anecdotal data suggest we may still be only in the early to mid-innings, with substantial buying by pension funds yet to go. In addition to corporate pension demand, part of the increased flows into fixed income could be demographicallydriven. The general aging of the population, combined with overall longer life spans, could be another fundamental factor causing increased retail demand for income-producing securities. Falling Dollar and Rising Deficits = Trouble for Bonds? Not So Fast. No discussion of the outlook for the bonds would be complete without addressing the risks from the weak dollar and the burgeoning US budget deficit. The US dollar. Since the spring, the US dollar has fallen 15%, as last year s crisis-driven flight to the dollar has now reversed. Increasingly, investors are asking: will the decline in the dollar prompt an exodus of foreign capital from the United States, resulting in higher rates, or even a funding crisis for the US government? If the past is any prologue, history shows the dollar to be a very unreliable indicator of future US Treasury yields. As shown in the graph below, the relationship between the level US dollar and long-term rates has been quite unsteady at best. Effective Exchange Rate US Dollar Effective Exchange Rate vs. 3-Year US Treasury Yields December 31, 19 September 3, Tsy Yields (%) 1 1 Effective Exchange Rate (US Dollar) 3-Yr US Treasury Yields Dec- Jun-3 Dec-5 Jun- Dec-9 Jun-93 Dec-95 Jun-9 Dec- Jun-3 Dec-5 Jun- In fact, if one is concerned about US dollar weakness driving US long-term rates higher, recent decades provide two striking counterexamples. In the chart above, you can see that from 195 through 19, as the dollar (on a trade weighted basis) lost a fourth of its value, 3-year US Treasury yields actually fell, from 1% to 7%. More recently, between January and September 3, as the dollar lost nearly one fifth of its value, 3-year Treasury yields, peak to trough, fell some bps. So, contrary to what one might expect, US Treasury yields actually declined significantly during the only two major dollar corrections of the past 5 years. These recent experiences certainly cast serious doubt on the notion that a US dollar decline automatically leads to higher interest rates. The US Budget Deficit. Next, we look at the US fiscal situation. While it may seem logical to assume that a shift from a substantial budget surplus to substantial budget deficit should lead to higher long-term interest rates, a review of history would counsel against drawing that conclusion.

5 Tsy Yields (%) Jan- 1-Year US Treasury Yields vs. Debt to GDP Ratio January 1, 19 June 3, 9 1-Yr US Treasury Yields Debt to GDP Ratio Jul- Jan-7 Jul-9 Jan-7 Jul-7 Jan-77 Jul-79 Jan- Jul- Jan-7 Jul-9 Jan-9 Jul-9 Jan-97 Jul-99 Jan- Jul- Jan-7 % 5% % 3% % 1% % Debt to GDP Ratio (X) Between 195 and 19, the stock of outstanding federal debt declined from % of GDP to 7%, while longterm interest rates rose spectacularly. A surge in inflation proved the dominant driver of the bond market over that period. Conversely, between 19 and 1993, as a substantial budget deficit lifted the outstanding federal debt from 7% of GDP back up, this time to 5% of GDP, 1-year Treasury rates actually fell from 1% to %. (Note: we have used 1-year Treasury yields in this latter example due to the lack of a time series for 3-year Treasuries prior to 19.) While high US government issuance of debt over that period undoubtedly had some upward impact on rates, once again, that influence was overwhelmed by other factors, in this case the disinflationary undercurrent of the day. We believe comparisons of the dollar and budget deficit with interest rates illustrate, if nothing else, that there is no clearly defined relationship among them and thus a change in one offers little predictive value as to the fortunes of the other. Only time will tell whether investors will wait this time for the fiscal situation to improve. In the meantime, the biggest single holders of US Treasuries the Japanese and Chinese governments certainly have no vested interest in precipitating a dollar crisis. After all, a dollar crash would serve only to devalue their trillions of dollars in reserves while simultaneously crushing the purchasing power of a very important customer: the US consumer. But, Will the Inflation Bogeyman Eat the Bond Market? With fiscal and monetary stimulus at full tilt, some have rushed to conclude that inflation will inevitably rise, slashing purchasing power and eating into fixed income returns. Similar to the economic recovery earlier this decade, we, too, expect this recovery to result in higher inflation over the near to intermediate term. However, just as in the previous cycle, we believe the rise should prove only temporary, with the Fed once again tightening conditions in time to prevent a pernicious wage price spiral. Those who fear the Fed will stand by idly as inflation runs amok are ignoring the consistent and credible price stabilization policies the Fed and other major central banks have adopted and carried out in recent decades. Conclusion Economic recovery notwithstanding, the outlook for fixed income continues to look reasonably positive. Longterm US Treasury rates are at attractive levels for this point in the cycle, as are credit spreads. Investors are moving out of their money funds into bonds. And, with the Fed funds rate likely to be near zero for some time, there s plenty of motivation for those record money fund balances to continue their trek into fixed income. Corporate pension funds, too, motivated to match their liabilities, are increasing bond exposure. And, while the dollar and budget deficits are certainly concerns, we do not expect either of these factors to overwhelm the generally positive backdrop for fixed income. 5

6 NOTES Copyright 9, Prudential Investment Management, Inc. Unless otherwise indicated, Prudential holds the copyright to the content of the article. Prudential Investment Management is the primary asset management business of Prudential Financial, Inc. Prudential Fixed Income Management (PFIM) is Prudential Investment Management s largest public fixed income asset management unit, and operates through Prudential Investment Management, Inc. (PIM), a registered investment advisor. Certain of the information contained in these materials presents performance returns of strategies using composites of Prudential Fixed Income, which is housed within Prudential Fixed Income Management. Prudential Financial and the Rock logo are registered service marks of The Prudential Insurance Company of America and its affiliates. The comments, opinions and estimates contained herein are based on or derived from publicly available information from sources that Prudential Investment Management believes to be reliable. We do not guarantee the accuracy of such sources or information. This commentary, which is for informational purposes only, sets forth our views as of this date. The underlying assumptions and our views are subject to change. There is no guarantee that the views expressed will be realized. Securities shown for illustrative purposed only and not intended to be recommendations or a complete listing. There is no representation being made that Prudential Fixed Income Management either held or did not hold any individual issues. 9-39

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