Getting your investment portfolio's bond allocation right will not be easy in 2010 amid conflicting views on inflation from investment strategists and policymakers.
Bond-fund behemoth Pacific Investment Management Co., or Pimco (AZ), said in a recent report it is now underweighting its holdings of Treasury Inflation Protected Securities (TIPS) because it expects a slowdown in the inflation rate this year. Pimco also said it would expect the Federal Reserve to rethink its promise to keep interest rates at record lows for an extended period of time.
But others worry the Fed may inadvertently prepare the way for an eventual surge in inflation by waiting too long to withdraw the massive liquidity it has pumped into the financial system for fear of causing a "double-dip" recession by reducing it too soon.
In a Jan. 3 speech, Fed Chairman Ben Bernanke broke with previous central bank policy, saying he would be willing to hike interest rates in order to pop future financial bubbles if other methods, such as regulations, appear not to be working.
David Joy, chief market strategist at RiverSource Investments (AMP) and chairman of the firm's capital markets committee, doesn't see Pimco's views and Bernanke's recent comments as necessarily contradictory.
It's possible for asset bubbles to form even when consumer prices are stable or in decline, Joy says. He believes Pimco's partial retreat from TIPS reflects the company's expectation of minimal changes in consumer prices, not its view on the possibility of more asset bubbles forming.
Many strategists, including Joy, believe the economy has too much slack for any meaningful rise in consumer prices in 2010. "At the same time, because of that, the Fed can afford to leave interest rates low, and that easy money can find its way into rising demand for hard assets like commodities and stocks. … In fact, the conditions that allow that to happen are exacerbated by low inflation."
In the past the Fed has focused on the general price level for goods and services, which is traditionally measured by the consumer price index (CPI), while ignoring prices of assets such as homes and commodities in the belief that although such assets may feed into inflation, they fall outside the purview of monetary policy. Bernanke's recent remarks may signal an expansion of the Fed's mandate to maintain price stability and maximize employment, says Joy.
Pimco isn't the only outfit urging investors to go light on TIPS this year. Michael Brandes, head of global fixed-income strategy at Citi Private Bank, the arm of Citigroup (C) that manages money for ultra-high-net-worth investors, recommended in a Dec. 14 report that investors underweight inflation-linked debt compared with other fixed-income asset classes, based on Citi's view of mild inflation in 2010. Citi still sees TIPS and related investments as a good way to hedge inflation risks in diversified bond portfolios over time, but it believes current valuations relative to potential price pressures aren't attractive. Five-year TIPS are now priced in expectation of a 2.25% inflation rate over the next five years, making them more expensive than when they were pricing in 1% to 1.2% inflation in the middle of 2009, Brandes says.
He urges investors who are still worried about inflation reaching 3% to 5% down the road to wait for a cheaper entry point into TIPS, which could occur if CPI figures start to come down in the months ahead. With inflation pressures so benign, he doesn't expect the Fed to start raising rates until the fourth quarter of 2010.
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