With the economic recovery appearing to gain momentum, investors may feel more confident about jumping back into stocks than they did in 2009. But looming questions about how the government's withdrawal of its enormous liquidity programs may affect economic growth—and concerns about another shoe dropping in the still-fractured credit market—suggest bonds will remain a key component of investor portfolios in the coming year.
David Bogoslaw of Bloomberg BusinessWeek spoke with Bill Larkin, a portfolio manager for fixed income at Cabot Money Management in Salem, Mass., on Dec. 23 about opportunities in the bond market in 2010.
Are you worried about what rising inflation could mean for returns in existing bond portfolios in 2010?
Inflation is determined by rising consumer prices, a loss of consumer purchasing power, and greater availability of credit. Almost 25% of the composition of the Consumer Price Index is rent, and we know that's going to be hindered [by the weak housing market], so consumer prices are not going to be a big part of the picture. Also, wages will be flat because of the weak labor market. Purchasing power is reversing [higher] a little bit with money being taken out of the economy as the government bank bailouts are paid back, but it's hard to forecast because you have to look at other patients in the hospital.
The dollar will continue to strengthen if there are problems with other countries' economies and the dollar is viewed as a safe haven again. Availability of credit will also be hindered throughout 2010. The difference in the yield on the 10-year Treasury note and the 10-year Inflation-Protected Securities (TIPS) is about 2.3%. As the bond market sells off, the market is getting ready for the normalization of interest rates, and a normal inflation rate around 2%. The yield curve is starting to steepen. That reflects supply going into the system next year as more Treasury bonds get issued. That means bond yields have to rise to attract enough buyers.
Doesn't a steeper yield curve indicate inflation expectations are rising?
The yield curve is steepening in response to the Fed saying it will be on hold for an extended period of time. The Fed has an inflation bias. It probably wants to see employment go up before it increases interest rates. The Fed is concerned about housing prices falling again, [which would happen] if interest rates go up too far.
Next year is the five-year anniversary of the low-interest-rate environment and the spike in refinancing mortgages with five-year adjustable-rate mortgages. A lot of these people are underwater in their mortgages, so they're locked out of getting a fixed-rate mortgage. There will be sensitivity there and the Fed is aware of this. They have the tools to address rising inflation but they don't have the resources immediately available to deal with a double-dip [recession], because their balance sheet is so stretched. So they need to see clear momentum in the economy before they will raise interest rates.
How soon do you expect the Fed to start raising rates?
I think the second half of next year will be stronger than the first half, although there's a possibility the economy rebounds faster than anticipated. There will be continued recovery, which we will be able to [monitor with] earnings and economic data. In the second half of 2010, the Fed will have to address the need to come off zero interest rates and will start to tighten [monetary policy]. It's likely to be very passive, to follow the market up as the market demands new returns to compensate for what it thinks the inflation rate will be.
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