Terrorist attacks, interest-rate cuts, recession set stage for interesting 2002

Northwestern Financial Review, Jan 1, 2002 by Laughlin, Tim

What are the questions you are faced with as you prepare for 2002? The following are a few questions that have come up in my recent discussions related to the economy, interest rates and their impact on bank bond portfolios:

What does a recession mean for interest rates? It's official - on November 25, 2001 the business cycle dating committee of the nonprofit National Bureau of Economic Research (there really is a group of professor types that do this) announced the United States had officially entered into a recession in March 2001. The record, 10-year long expansion, known as the "goldilocks" economy, had ended. In reality, a number of key economic indicators were starting to show weakness in autumn of 2000. Yet the Fed, thanks to the chaotic political environment of the 2000 presidential campaign, stayed away from easing the Fed Funds rates. In 2001, therefore, the Fed was forced to play "catch up," implementing the most aggressive rate cutting campaign in the history of monetary policy.

Rates will move higher; they simply cannot move much lower given their 40year lows. A combination of aggressive fiscal and monetary actions will reverse the economic downturn. Encouraging consumer confidence reports (consumer spending accounts for two-thirds of the GDP) and lower energy costs will also help the economy.

How long will the recession last? History usually provides good insights into the future. Since World War II, we have had nine recessions lasting a total of 96 months. Since 1982, we have spent only eight months in recession. Recessions during the 20th century have lasted from seven to 43 months, with an average length of 15 months.

Yogi Berra once said, "It's like deja vu all over again" and history does repeat itself. Based on history, we should start to see some signs of economic growth in late second or early third quarter of 2002.

Will the Fed reverse gears in an aggressive way? Following deep rate cuts in 1993 and 1998 the Fed had to move rates markedly higher in 1994 and 1999. Historically, there is, on average, an 11-month span between a change in Fed policy. The shortest span has been five months.

Following the September 11th terrorist attacks, the Fed quickly moved to help the market. The Fed pumped $81 billion dollars of emergency liquidity into the financial system. Furthermore, investors were forced to discount for a new level of unpredictability in the stock market, which drove funds to the safety of the bond market. The combined impact of these actions was that bond yields were driven to remarkably low levels.

At some point the Fed will want its money back! Also, as we continue to get good news from the war on terrorism, some of the fear and uncertainty built into bond prices will be taken back. The net effect is that short-term yields could move back toward their pre-September 11 levels, which were in the 3.50 percent range.

Will the cancellation of the 30-year bond affect the capital markets? As bankers, we lost a key benchmark in November 2001, when the government announced it was suspending the auction of the 30-year bond. How will longterm mortgages be priced when the "benchmark" is gone? Will traditional yield curve relationships change? What will long-term investors (such as insurance companies and pension funds) do nom? Will other borrowers (corporations and agencies) start issuing 30-year bonds to fill the void?

What should I do how with my investments? First of all, do not panic, Given the low rate environment, it is better to be short (with another chance) than long and wrong. Focusing on shorter-term investments (such as short, well-structure PAC CMOs and municipal bonds) will reward you down the road. Also, stagger the timing of your investments. Evaluate your current cash position and deduct the amount you will need in Fed Funds for your normal cushion and pending loan demand. Then, ladder the excess funds back into the market over a specified period of time in a methodical, non-emotional manner.

Happy New Year? Hopefully. The combination of the terrorist attacks and the struggling economy made 2001 a year I would like to forget. I believe that 2002 will be remembered as the year the world became a safer, more peaceful place and we returned to a better economic environment.

Tim Laughlin is assistant vice president in the Investment Banking Division of UMB Bank, N.A., Kansas City, Mo.