Noyes Capital Management, Llc

NOYES CAPITAL MANAGEMENT, LLC
Financial Planning, Investment Management, Pension Consulting
PO Box 271, New Vernon, NJ 07976
www.noyescapital.com
(973) 267-8120

By Scott P. Noyes, CFA® CFP®
August 10, 2004

“A Mulligan for the Bond Investors”

A convergence of events in the bond markets is offering a rare mulligan for fixed income investors to sell bond positions in August. This is created by three recent events that caused a squeeze in short or underweight positions from hedge funds and bond mutual funds. These events include the recent payroll employment data, which was weaker than expected and has brought into question the Federal Reserves rate hike path. Continued terrorism worries have imbedded a fear premium in the bond market, particularly through the Olympics and Republican convention in early September. Also, the recent high oil prices are considered by many to be an indirect tax on the consumer and will cause a substantial slowing of economic growth. We believe that these events are transitory and offer investors a great opportunity to sell bonds or fixed income mutual funds at good prices. Yields in the 4.00% to 4.20% in the US ten-year treasury are thought unsustainable.

The recent payroll employment number that showed payroll growth of only 32,000 jobs in July does not pass the sniff test. Economists have never been good at forecasting this piece of economic data. With a robust household employment survey and economy growing at a 3% clip, we fully expect to see either a rebound in the August employment data or revisions to past data in the next jobs report in early September.

The media and politicians are playing on our terrorism fears. Many people are surprised and impressed that there has been no follow-up terrorist activity in the US. This is a compliment to higher security standards and vigilance from the police and general public. It is clearly much more difficult for a major terrorist event to occur. While all possibilities cannot be eliminated, a minor act should not have a long lasting affect on the US economy. If we get through the Olympics and Republican convention in early September without a problem, some of the terrorism premium should ebb from the marketplace.

Oil prices have spiked based on terrorism fears, potential supply cuts in Iraq and Russian, and high levels of hedging from end-users. High levels of momentum-based speculation from hedge funds and trading accounts have exacerbated the recent price increase to $45 per barrel. Investors should not be surprised if an announced increase in supply or diminishing demand causes a dramatic drop in oil prices. This could be caused by a reduction in purchases for the strategic petroleum reserve, stabilization of supply in Russia or Iraq, or a positive message from Saudi Arabia.

The Federal Reserve is on a tightening path that will likely reach or exceed a 2.00% to 2.25% Federal Funds Rate by January. Allan Greenspan frequently focuses in the GDP Deflator as a measure of inflation. This index is currently growing at 2% rate and is expected to increase to 2.4% by year-end. If the economy remains reasonably robust, it will be difficult for the Federal Reserve to keep short-term interest rates below the implicit rate of inflation for much longer.

We advise investors to reduce their exposure to longer dated maturities when ten-year interest rates reach 4.0% to 4.2%. We believe that within the next six to nine months, investors will be able to buy the same bonds with yields of 5% to 5.25%. When nominal yields are near 4% it is important to avoid significant principal loss that could be as much as 10% to 12% on a 1% rate increase.

We recommend that investors consider short-term bank loan funds such as the no-load Fidelity Floating Rate High-Yield Fund (current yield of 3.08%) or liquid securities maturing in one to two years (1.75% to 2.5%). We do not believe the extra 1.5% in yield differential warrants the risk of serious principal loss over the intermediate term.