James Bianco: Macro Analyst weighs in

Instead of focusing on specific securities in the equities and fixed-income markets, Bianco concentrates on the macroeconomic forces that move entire sectors. His latest analysis of these big-picture trends, including the flattening yield curve, weakening dollar, rising oil prices and the machinations of hedge funds, have led him to be bullish on energy and bearish on health care.

We are looking at the fixed-income market. Regardless of what you think rates are going to do, what is the strongest and most undeniable trend in fixed income is that the yield curve continues to flatten. In the long term, it continues to hover around 4.4% to 4.5%, which produces a flat yield curve. In 2001, 40% of all corporate profits were generated by financial companies. That number was 18% in 1998, and 4% in 1982.

When everybody talks about corporate profitability and S&P earnings, they're talking about financial earnings, because that's the largest sector. What largely drives financial-company profitability is the yield curve. You will see the yield curve continue to flatten, and financial companies continue to get squeezed. Long-term and short-term rates will continue to converge with each other, and will make it harder for those companies to make money.
Here's what the Fed's doing: Greenspan's leaving in nine months. He doesn't want to hand the reins to a new Fed chief out of line of a neutral policy, a "measured pace" is what they always say. So when he hands the reins over to the new guy he won't have to do something immediately. That's why I find it surprising, when people ask why are bonds going down? They're trying to reposition themselves at neutral so Greenspan can exit gracefully. They're not trying to slow anything down. They're not trying to stop something. Until they do I think you shouldn't be surprised that the market's been reacting the way it has to the funds rate.

Why is it that the bond market has been able to meander sideways in the last couple of years? It hasn't really gone down or gone up. I think the answer is, who is the buyer of Treasury securities? It is not somebody who has an opinion about the economy or inflation. It is a foreign central bank, or hedge fund, which is an alpha buyer — somebody long and short at the same time. They do not care about inflation, or the economy.
The effect is that they've been holding interest rates largely at these levels despite what people think they should be doing. People think interest rates should be higher. None of that stuff — Fed policy, the economy — is moving interest rates. What is moving interest rates is the dollar, the shape of the yield curve, hedge-fund strategies, the state of credit markets. It's not about inflation, growth or deficit. That has had no effect on interest rates because those are not the issues that matter. Everybody talks about them because they're easy to talk about.
Well, what does it mean to be a hedge fund? If you're a mutual fund, you're a beta manager. If you're a hedge fund, you're an alpha manager. It's critical to understand this. When you're a beta manager, what is going to determine your returns is the volatility of the market. If the stock market is up 28% for the year, if you're a good manager, you're up 30%; if you're a bad manager, you're up 18%. You're up big either way.
What largely determines your return is the state of the market. An alpha manager says, I have a strategy — it might be playing the shape of yield curve, etc. — and I can return to you 6% every year, guaranteed. We can have war, pestilence, locusts, doesn't matter. If you can give me 6%, and the fed-funds rate is 3.25%, of course I'll give you my money. Hedge funds don't buy anything. They buy and sell at the same time; they try to exploit those efficiencies. Those strategies have been largely leading to net purchases of the market. They're not doing it because they have an opinion about the market. And as a byproduct, they're holding down interest rates.