Letter to the Shareholders: March 31, 2017

Dear Shareholder:

The Federal Reserve met on March 15 and raised the fed funds rate an additional quarter point to ¾ to 1 percent. This was the third increase in the current rate hiking cycle. Once again, the Fed reaffirmed its view that additional rate hikes would be gradual and that rates would likely remain low for some time. The bond market interpreted this news as mostly “dovish”.There were no ‘hawkish” pronouncements and essentially no material changes to the Fed’s economic forecast.

The Fed’s economic projections continue to call for the fed funds rate to rise gradually over the next three years with the median fed funds rate topping out at 3.0 percent at the end of 2019. These projections are based, in part, on assumptions about what the “neutralrate” of interest is. In layman’s terms, the neutral fed funds rate can be thought of as sort of a “Goldilocks” rate, meaning a rate that is neither expansionary nor contractionary, but one that keeps the economy operating on an even level. In response to questions during the press conference that followed the meeting, Chair Yellen stated that her long-run assumption for the neutral rate is “1% or a little under”. This is a key piece of information because it helps explain the Fed’s current thought process about the appropriate interest rate policy path going forward.

At the risk of oversimplifying things, here’s a stab at explaining how the Fed’s current math and thinking works. The Fed has set an explicit 2% inflation target. If the Fed increases the nominal fed funds rate to 3.0% and inflation is running at 2.0%, then the real fed funds rate which is adjusted for inflation is equal to the neutral rate at 1%. In a perfect world, that is where the Fed would like things to end up in the long run–a rate that is not too hot, and not too cold. Currently, the inflation rate is around 1.80% and the upper range of the nominal fed funds rate is 1%. This means that the real fed funds rate right now is somewhere around -0.80%. Thus, from the Fed’s perspective, its current monetary policy is still very accommodative.

The Fed has begun to reduce the stimulus that it has been giving the economy by gradually nudging the feds fund rate up. In monetary policy jargon, this process is referred to as “taking away the punch bowl”. At some point, the Fed will start to reduce the size of its balance sheet which will also serve to reduce the amount of economic stimulus. The Fed has consistently stated that its policy decisions going forward will be data dependent.

So what does the recent incoming economic data look like? Most of the data reinforce the idea that the economy, in its seventh year of expansion, is continuing to grow at a modest pace with inflation staying relatively subdued. The Commerce Department released its third and final fourth quarter GDP estimate and revised it up slightly from 1.9 to a 2.1 percent annualized rate. The Fed’s economic projections call for real GDP growth to average around 2 percent for the next three years. The Fed’s preferred inflation gauge,·the core PCE, rose at an annual rate of 1.8 percent in February. The unemployment rate in February was 4.7% which is approaching full employment. While the incoming economic data continues to show improvement, we don’t believe it is strong enough for the Federal Reserve to deviate substantially from its “gradual approach” message anytime soon.

We think there is a good chance the current rate tightening cycle may play out in similar fashion to the last tightening cycle with one notable difference. The last interest rate tightening cycle lasted approximately two years from June 2004 to June 2006. During this two year time period the Fed raised the fed funds rate 17 times in 25 basis point increments. The fed funds rate started out at 1.25% and topped out at 5.25%.

It might surprise you to learn that during this two year time frame, municipal bonds experienced positive total returns as measured by the Bloomberg Barclays Municipal Bond Index. Among other things , this is a testament to the value of the income stream generated by bonds that helps to offset price declines. Suffice it to say, for fixed-incomeinvestors, income really does matter. While it is true that a sudden increase in yields can cause an immediate capital loss for fixed-income investors, the long-term total return impact to bonds is generally positive.

Most indicators suggest that the current rate cycle will be a gradual one with small incremental increases in the fed funds rate. However, we think this interest rate cycle will be much shallower than previous cycles meaning that the ultimate or terminal fed funds rate will be much lower than in previous rate cycles. Interestingly, economists at the Fed just published some new research that suggests that the neutral rate may be closer to zero than 1%. If this is true, then it may have significant implications for where the fed funds rate ultimately ends up (e.g., a zero percent neutral rate with 2 percent inflation would support a 2 percent nominal fed funds rate).

While we are relatively confident about where we think things are going from a monetary policy standpoint, the wild card in all of this is fiscal policy. The bond market experienced a selloff back in November on fears that a new Trump administration agenda would lead to more robust economic growth and higher levels of inflation. We mentioned in our last shareholder letter that we felt the “Trump trade” and resulting bond market selloff were somewhat overdone and that the bond market would eventually find its equilibrium. Some of what we said appears to have been accurate. There certainly is nothing easy or quick about pushing a legislative agenda through in Washington these days! The bond market has staged a small rally with yields declining (prices up) as it has become apparent that policy changes will take significantly more time than the market originally priced in.

In our opinion, the bond market will probably trade in a pretty narrow range over the next couple of months as the new administration’s fiscal policies take shape. In the meantime, probably the best advice we can give you is to “keep calm and carry on”. We have said it many times before, but we think it is worth repeating: buying high quality bonds and holding on to them for the long term is almost always a winning strategy.


Thank you for investing with us.

Very truly yours,
Allen E. Grimes, III
Executive Vice President