Longer dated treasury securities have been on a tear. In 2011, the benchmark 10-year Treasury notes produced a total return of 21.64%, spectacular by any yardstick; especially when you consider that ultimately, there’s no principal risk.
On Monday, Chairman Bernanke expressed the Fed’s view that the economic recovery and labor markets still needed accommodative monetary policy.
Market participants took this statement as an indication that the Fed may be ready to launch a third round of quantitative easing (QE3). Subsequently, several commentators discussed the possibility of endless low rates.
But in my view, the trade in 10-year T-Notes is over and it’s time for investors to switch into shorter-term corporate bonds. I view Chairman Bernanke’s statements as factual–the recovery is sustainable, but a little help from the Fed can’t hurt.
Our view, at GGFS, is that as long as there are little signs of core inflation and labor markets continue to improve, the Fed is unlikely to take action to further manipulate interest rates.
As a matter of fact, when reading transcripts of all recent Fed speeches and congressional testimonies, it is clear that the “dream scenario” for the Fed is to keep the official interest rate policy, meaning short-term rates, at current levels, while only experiencing mild core inflation and improving labor market conditions.
Under this scenario, which we are experiencing, the Fed will be well served–in particular politically–by allowing markets to drive longer dated maturities higher, without interference.
Based on this, I believe smart investors will start focusing on high-grade, shorter-term corporate bonds. High-grade corporate bonds represent a haven of sorts at the moment because there is little risk to principal in them, in particular as the U.S. and the world economy improves.
Since picking individual bond issues can be tricky, I would recommend investors execute on this strategy with mutual funds or exchange-traded funds. Vanguard Short Term Corporate Bond (VCSH) and Pimco Low Duration (PTLDX) are two examples.
As for getting out of T-Notes, keep in mind rates began the year at 1.97% and now stand at 2.25%, an increase of about 15%. I think the trend will continue, and it bumps up against one of our cardinal rules for preserving capital: Don’t fight central banks or, for that matter, anyone else who can print money. The reality is the Feds could bring these rates down literally in minutes, and that they haven’t after a 15% rise suggests they are willing to let market forces exert their influence for the foreseeable future.
In my view, as long as unemployment numbers continue to improve, and there is little sign of core inflation, the current scenario is likely to play out as market forces wish, not as the Fed dictates.
Separately, I am also detecting early whispers that the Federal Reserve Bank Open Market Committee (FOMC) might change its language regarding interest rate policy ever so slightly. I am in the minority camp that is disagreeing with Pimco’s Bill Gross, who recently stated his view that the Fed will hint at QE3 in their April meeting.
I, and a very few others, believe that the tide is shifting, and that the minutes may actually show that more voting members are indicating that a rise in short-term rates may be necessary as early as first quarter 2013–not the currently predicted end of 2014.
Special Offer: Get 13 undervalued stocks from value expert John Buckingham in the Free Special Report 2012: Time For Value. Click here for instant access.
Moving out of Treasuries and into corporate bonds might also do other good things for you. First, if you were smart enough to figure out that T-Notes were going to rally, getting out of them will enable you to lock in your gains, at a capital gains tax rate (certainly the lowest tax rates we expect for many years to come). Second, by switching to shorter-term corporate bonds, I think you will avoid a whole lot of volatility as the Treasury bubble bursts–an inevitable event if you ask me.
That’s right, I did call it a bubble, and I did say it would burst. I’m not the first portfolio manager to advance this idea. I don’t see it as particularly radical. That’s because I believe there’s too much focus on the bursting of a bubble, and not enough emphasis on what’s really important. And what’s really important is that the world economy is improving with the aid of governments, and that’s not going to change because of what happens in the Treasury market. So, remain calm, and carry on.