2007 Forecast

Well, everyone else is doing it, so I will too. What might be different about my prediction column is that I’m going to write it the way I make portfolio decisions. There will be two elements. First, the most likely scenario, and second a less likely, but possible scenario. When I build portfolios, I try to perform best in the most likely scenarios, but also perform at least OK in the possible scenarios.

I’m going to go out on several limbs here, making as specific a forecast as possible. Most forecasters don’t do this as it makes it easier to claim you were right later. Still, why not be detailed? The odds of all my forecasts coming to fruition are low anyway. Why not explain in detail the timing, levels and reasons why I think what I do. The reader is smart enough to agree or disagree or call me an idiot.

Without further adieu…

Economy: Most likely - Mild slowdown with decelerating inflation.
Housing will weigh on the economy in 2007, in terms of lost jobs from construction and reduced mortgage equity extraction. However home price declines will be modest in most areas and the housing market will clearly be recovering by the end of the year. Business investment will remain strong, and this will help keep any decline in consumer spending from causing a more severe slowdown in overall growth.

Possible - Recession with deflation scare.
This would most likely occur because consumer spending is weaker than I expect, which leads us into recession. This might be because the housing market is worse than I expect, or that business spending pulls back resulting in layoffs. Weaker U.S. imports will cause a global slowdown, pushing energy prices lower. If this comes to fruition, the Fed’s current monetary stance will turn out to be too tight, resulting in rapidly declining inflation figures in mid to late 2007, possibly bringing back talk of a deflation.

Fed Funds: Most likely - 4.75%.
The Fed traditionally takes one or two hikes back after a tightening campaign. Once it becomes clear inflation is slowing, the Fed will make two cuts. The first will likely be in June and the second most likely in August. At that point, the market will price in no further Fed action for some time.

Possible - 3.25%.
If the economy does slip into recession, the Fed will be forced to act quickly. Since it will probably already be May or June before they make their first cut, look for the Fed to cut at every meeting for the rest of the year, possibly including a 50bps cut at some point.

10-year Treasury: Most likely – 4.90%
There are currently more than 2 Fed cuts priced into the market, so when the more bullish bond investors are disappointed, rates will wind up rising. For most of the year, the 10-year will hang around 4.50%, possibly rallying even further, but once it becomes clear the Fed is done (probably 4Q) the 10-year rate will move rapidly higher. Intermediate and long-term rates will also be under pressure from Europe, where rates will be rising more significantly. Keeping rates from rising more rapidly will be the generalized belief that the Fed will be on hold at 4.75% for some time as well as continued demand from overseas.

Possible – 3.70%.
If a recession hits and the Fed cuts aggressively, longer-term rates will have to fall. 10-year rates will bottom out sometime around August then hold for the rest of the year.

2-year Treasury: Most likely – 4.70%
The 2-year will be stuck near where they are now all year. Currently, the 2-year has some period of 5.25% priced in, and some period with rates 75 bps lower. While I think the Fed will only cut twice, the period of 5.25% currently priced in will be eliminated, resulting in a lower 2-year than we have now. Note that this doesn't mean that buying the existing 2-year will necessarily be profitable. I’m speaking of the 2-year that is sold in December 2007. This implies a dead-flat slope between Fed Funds and the 2-year, and a slightly positive slope between 2-10.

Possible – 3.35%.
If the recessionary scenario emerges, the 2-year should follow the funds rate down, but some steepness will emerge toward the end of the year. The steepness theory is based on looking back at the 2001-2003 cutting cycle. Fed funds vs. 2-year Treasury remained inverted for only 6-months after the first cut, even though the Fed continued to cut rates for two more years.

Investment-grade Corporates: Most likely – Mildly wider, outperforms Treasuries.
While I see corporate profits remaining fairly strong, corporate spreads will likely suffer due to increased supply and continued shareholder-friendly activity. However, the widening will not be enough to overwhelm the income effect. Financials will outperform industrials.

Possible – Much wider, underperforms Treasuries considerably.
Corporate spreads are historically tight, so should corporate profits come under pressure, spreads will widen considerably.

High-yield Corporates: Most likely – Wider, underperforms investment-grade corporates.
High-yield has suffered historically low default rates over the last 2 years, and issuance volume has been increasing since 2002. Historically, this has been a recipe for higher default rates. I think this begins happening in mid-2007.

Possible – Dramatically wider.
The same idea as investment grade corporates, but even more so when dealing with high-yield.

MBS spreads: Most likely - Tighter.
MBS will benefit from increased buying by foreigners and banks, and supply will remain tight as housing activity is light.

Possible – Wider on higher volatility
Should rates fall substantially, both convexity problems and higher volatility will push spreads wider. Protection against this includes buying FNCL 5’s, which have decent convexity.

Please keep all laughing to a minimum.