Storm on the Long End

Did Katrina solve Greenspan's yield curve conundrum?
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Hurricane Katrina may have flattened the Gulf Coast, but bond fund managers say it's having the opposite effect on the yield curve.

Wall Street expects the

Fed

to raise interest rates for an 11th straight time when it meets later Tuesday. The Fed's main target is inflation, which was creeping up due to higher energy prices even before the storm hit. The Labor Department's August consumer price index, released last Thursday, showed headline inflation rising 0.5%, thanks to surging energy prices. Stripping those out, the so-called core CPI rose a more benign 0.1%.

Unfortunately, the best-laid plans of maestro Alan Greenspan and his men and women at the Federal Open Market Committee have gone astray. Long-term rates have remained depressed even as the Fed has frantically tightened the short end.

But that may be changing due to the aftereffects of Katrina. The yield on the 10-year Treasury has jumped 25 basis points to 4.25% since Katrina ravaged the Gulf Coast. Now, a number of bond fund managers are predicting that yields could head even higher as inflationary expectations rise with the costs of recovery and reconstruction.

"Katrina has been able to do what Alan Greenspan has not, which is find a way to rapidly lift long-term rates," says Steven Bohlin, managing director at Thornburg Investment Management.

Bohlin points out the prices for materials required to rebuild the battered region, like lumber and cement, are hitting new highs. Both commodities were already in a demand-based bull market prior to Katrina due to the housing boom. Mexican cement manufacturer

Cemex

(CX) - Get Report

, for example, has seen its shares rise by more than 10% since the storm hit.

Other commodities, like gold, also have been surging in response to the inflationary threat of the government's $60 billion bailout package. Gold, the safe haven in an inflationary environment, has moved to its highest point in well over a decade to more than $460 an ounce, and is up more than 7% since the start of the month.

Oddly, the one commodity that has fallen in price since the storm is oil, although the process began to reverse itself on Monday in the face of Tropical Storm Rita. Oil prices already had been reaching record highs of $70 a barrel prior to Katrina shutting down production in the region's refineries.

The mammoth aid package, on top of an already growing federal deficit, has a number of money managers starting to see higher yields ahead as more money is pumped into the economy. Inflation is often characterized as "too much money chasing too few goods." And there is certainly a lot of money heading south.

Bob Doll, chief investment officer of Merrill Lynch Investment Managers, wrote this week that equity prices have been supported by continued low longer-term yields, but "there is a risk that yields will move up in the face of inflationary pressures or fiscal worries."

"We are concerned that with Washington paying so much attention to hurricane relief, high gasoline prices and Supreme Court vacancies, the federal budget has taken a back seat," notes Doll.

Katrina's impact has turned even Morgan Stanley economist Stephen Roach from a bond bull to bond bear. In a note to the firm's clients last week, titled "Last Hurrah for Bonds," Roach said, "Courtesy of an energy shock and post-Katrina repercussions, the bond market's bearish stars are now coming back into increasingly worrisome alignment."

Bond fund managers also are being forced to consider whether the tidal wave of federal dollars bound for the Gulf Coast will counteract the Fed's attempt to siphon excess liquidity from the economy through its procession of rate hikes.

Bohlin says the two forces will offset somewhat but, more importantly, it allows Greenspan to continue tightening rates so the incoming chairman does not have to. "Or can lower rates if necessary," Bohlin says.

Not all bond fund managers believe that Katrina has the power to lift long-term rates, however. Mark Kiesel, fixed-income portfolio manager at

Pimco

, says that Katrina-based inflation will probably be temporary. In his view, as well as Pimco bond guru Bill Gross, long-term rates will remain low as long as there is no significant wage inflation. Pimco's official outlook is for 10-year Treasury yields to remain range-bound between 4% and 4.5%.

"The labor markets are becoming global with India and China supplying additional workers in the service and manufacturing sectors," says Kiesel. "That will keep wages in the U.S. contained, which means inflation won't pick up and rates will remain low."