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How the Bond Markets React 08.28.06
Short-Term Pays Off - for now
I'll admit that I have been lax in my coverage of the bond markets. What was there to report? Aside from the emerging market meltdown in May, now since recovered, fixed income investors who did not seek over-the-top risk in foreign debt, the best place to be was in short-term certificates of deposit and money market accounts.
As Ben Bernanke, the Federal Reserve Board chairman raised rates, continuing what his predecessor Alan Greenspan began, the returns on these low risk investments rose as well. With net returns approaching 5%, fixed income investors became well-rested individuals.
But all good things must come to an end and the impossibly safe money market account will begin losing ground if inflation rises much further or the Fed begins to lower the short term overnight rate it charges its best customers. Experts say this will begin some time next year. I had predicted that it would have begun by now and it should have had we reached this level months ago with quicker more harsher tightening.
By slowly tightening, the economy was given a chance to continue to expand, defying many of the most seasoned of investor's predictions. But that expansion is showing signs of slowing even as some global economies heat up. Housing and confidence will begin to taper off and only with luck, will is be a gradual process.
Talk of recession has made it to the evening news although no one is quite certain of when or how deep it might be. If it does materialize, it will not be a gentle one on several levels.
The fear of a wage price spiral has been replaced with a simpler price spiral and with it, the possible loss of jobs. A wage price spiral suggests that as prices increase, workers demand more money as compensation. Companies are forced to pay these workers and raise prices again to pay them.
The phenomenon of yield curves once again comes into play as the interest rate cycle shifts. When rates are higher for short-term maturities, it is usually based on the belief that inflation is present. When long-term rate rises though, the belief that inflation will be tame or tamer in the future is also built into the offering.
When the Fed raises rates (and they should do so only to achieve price stability not as a reaction to housing prices or jobs numbers), the long-term rates should rise in tandem.
Only during this tightening, they did not, defying a trend that many fixed income investors have relied on. Could the two maturities be permanently decoupled? What then would signal fixed income investors that it was time to look for better returns elsewhere than the risk-free ones they are currently using?
The stock market could be the next best indication that yields will increase (and bond prices will fall). With short-term, six-month T-bills yielding 5.2% (at this writing 08.26.06), and the long-term 10 year bond well below 5% at 4.84%, the stock market could begin to heat up significantly towards the end of the year.
Should you jump in now? Probably not. Should you buy junk to improve your return and increase your exposure to risk? Iąm not so sure this would be a very wise move either.
Should you defy logic and try to catch the tailwind of REITs as they profit from the housing downturn as they see an increase in people who would rather rent than buy? Once again, not necessarily a good strategy considering the long run these investments have had. Although those double-digit gains are tempting, avoid them and do so with maturities that donąt extend more than two years.
Why two years? It allows you to ladder your short-term investments in a more narrow range. Laddering a fixed income portfolio is a strategy that buys numerous maturities so when one note expires, it can be reinvested. Unladdered portfolios have fixed income securities that expire on the same date. Keeping the horizon short might be all you need to be in the right place at the right time.
Until then, sleep well with your money market accounts and short-term maturies in CDs and wait.
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