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Fixed Income Investors May Be In For A Surprise

 January 07, 2013 09:29 AM


Since the financial crisis that saw the market (S&P 500 Index) bottom in March of 2009, investors have allocated more of their investment dollars to bonds versus stocks. This allocation decision has resulted in investors missing out on the much stronger returns generated by stocks. Out of the last four years only 2011 saw bonds beat stocks in the U.S. investment market.

This allocation decision made by investors is confirmed by fund flow data as shown below.

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Complicating the analysis for investors on where to allocate investment dollars has been the Federal Reserve's involvement in artificially forcing interest rates lower through Quantitative Easing activities. Looking at the monetary base, however, it appears the Fed may have stepped away from easing recently in spite of the Fed's rhetoric.

The monetary base expansion has not led to higher inflation as the turnover or velocity continues to decline. The significance of velocity is outlined in an earlier blog article,  Money Supply Causing Concern With Future Inflation.

In fact, St. Louis Fed President James Bullard indicated as much in a recent interview on CNBC. A part of his concern is the improving unemployment situation, albeit at a very slow pace, and maybe improved commercial lending activity at commercial banks. It is the banks' deployment of excess reserve into loans that will have a positive impact on the velocity of the monetary base.



Then what is the significance to investors? Potentially higher interest rates. The consequence of higher interest rates is a decline in the price of fixed income (bonds) prices as prices move inversely to interest rates. In the short term this appears to be occurring. Since early December, the price of the 10-year treasury has declined by 2.18%. Investors underweight equities should consider the negative impact of higher interest rates on their fixed income investments.

With the fiscal cliff recently avoided, equities responded favorably. However, Washington has ensured investors of more uncertainty in the near term with debate on the debt ceiling, cuts associated with sequestration and the federal budget's continuing resolution negotiation. All of these may provide investors the opportunity to consider higher equity exposure if they are underweight this asset class. Keep in mind the higher taxes associated with the fiscal cliff agreement and additional taxes associated with the health reform act have the potential to reduce economic growth. This alone could be negative for the equity markets though.

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