One of the most dramatic pieces of news in recent months has been the sharp increase in unemployment.  May ’09 figures showed the national unemployment rate at 9.4%.  This represents a 3.9% increase over 12 months, which ultimately means that unemployment is 71% higher than it was in May of 2008.  During this period of time, the consumer price index fell quite considerably due to dramatic reductions in energy prices from the demand disruption that was caused by the global credit crisis.

We believe that energy prices will regress back to their long-term equilibrium as credit markets normalize.  This is likely to contribute to a ‘double whammy’ with the monetary inflation that is expected to result from the Federal Reserve policy to expand the money supply as a tool for fighting deflation.  In addition to this, it is unclear how much more employment will contract as the economy grapples with the new realities of tighter credit and increased government intervention.

The recent month has been a very volatile time in the credit markets.  The most noted phenomenon is the resurgence of the ‘bond vigilantes’ who are liquidating positions in US Treasuries to diversify into other debt holdings.  This phenomenon has begun to push up treasury yields relative to prior months because of concerns by funds and governments holding major positions of US bonds that the loose monetary and tremendous government spending obligations will compromise the fiscal stability of the United States.

As the recent monetary expansion by the Federal Reserve plays out, we are expecting to see one of two scenarios transpire.  The first scenario is that when credit markets normalize, the Federal Reserve will contract the money supply to keep inflation in check.  This will have the result of pushing up short term rates, and will likely trigger a sell-off of long-term securities by investors that are looking to capture higher yields by re-buying shorter-term products at higher interest rates.  The second scenario is where the Federal Reserve simply leaves the monetary system expanded, and inflation rolls through the economy.  In this case, we expect to see many bondholders liquidate their positions as the returns are eroded by inflation.  This will also have the effect of pushing up yields.

In the end, there is an extremely high likelihood that future events will be pushing up interest rates.  Because of this, prudent investors should seek to lock down as much fixed-rate debt as possible while the rates are in a temporary trough from the global financial crisis.  It is impossible to determine how much longer the current low rates will persist, but it is very probable that they will climb rapidly once they begin moving up and will be elevated for a considerable length of time before coming back down.