Cash rules as the Fed tightens the screws

Cash is once again king in the US Treasury market. Investors are yanking money out of longer-term securities, like 30-year bonds, and shoveling it into shorter-term bills and notes. They're looking to limit the losses they suffered in the wake of the Federal Reserve's decision in March to raise borrowing costs to slow economic growth and keep inflation at bay.

Growing indications that another interest rate rise may be necessary is also fueling the exodus to bills.

The latest warning sign came on Friday, with a report showing the US unemployment rate fell in March to its lowest level in five months, accompanied by an acceleration in labour costs and record overtime.

That means the Fed is likely to continue raising rates, analysts said. "The Fed will tighten at the next meeting" said Nick Perna of Fleet Financial in Connecticut, and may eventually boost the rate as high as 6.25 per cent from the present 5.50 per cent. Hence the allure of bills.

Bills, considered equivalent to cash, are often the best investment when rates rise rapidly because their prices fall less than long-term securities as borrowing costs go up. They also mature faster, so investors get their money back quicker and can invest it in newer, higher-yielding securities.

Fund managers who run portfolios of longer securities are also looking to minimise their risk. Wilmington Trust Co's Eric Cheung said he's been selling 30-year and 10-year bonds and buying two-year notes.

"I'm in the camp where I see more tightening moves ahead," said Cheung.

If history is any guide, investors need look no further than when the Fed last began to raise rates in February 1994, said John Breazeale, asset manager for Weiss Money Management in Florida.

"Believe me, I've been through this before," said Breazeale, who began trading bonds for Lehman Brothers in the early 1970s.

He has the majority of the securities he manages invested in bills and notes in expectations that long-term yields could climb to 8 per cent before the Fed is done.

When the Fed last moved in 1994, it wound up raising rates seven times over the next year, doubling the federal funds rate to 6 per cent. During that period, the yield on the 30-year bond climbed more than 150 basis points.

Bills were the best performing government securities then. Three-month government securities posted a total return of 4.50 per cent in 1994, while the 30-year bond fell 12 per cent, according to Ryan Labs Inc, a New York-based bond research company.

Of course, few investors expect interest rates to climb as much as they did in 1994. Also, since inflation hasn't shown any signs of quickening, more Fed rate increases might not be needed.

Consumer prices, one of the most frequently used indicators of inflation, rose at a 2.3 per cent annual rate during the first two months of the year, down from 4.0 per cent during the same period in 1996.

And if investors think the Fed will be able to slow the economy quickly, long-term securities will actually rally most.

"Ideally you want to roll into [higher securities] when you think rates have peaked, but it's a matter of when," said Breazeale. Copyright: IOS & Bloomberg