Opinion

James Saft

Bonds living on one lung: James Saft

April 26, 2012

By James Saft

(Reuters) – Guess what, bond investors: just like the Federal Reserve, you are trapped.

The Fed on Wednesday said it was keeping rates on hold until at least late 2014 but failed to tip its intentions clearly about any possible additional round of quantitative easing. The Fed once again stressed the “significant downside risks” from “strains in global financial markets,” a nod to the backwash from euro zone issues, having eliminated this language from its last statement.

Going strongly into equities seems brave given the bumpy recovery and with continued risks of fallout from Europe, even with an implied promise of a safety net from the Federal Reserve. That leaves the rather unlovely option of government bonds, now 30 years into a bull market and offering low yields and the, distant, possibility of big losses when the Fed eventually hikes rates or gets behind the inflation curve.

“The Fed can no longer do what it once could, which is to take preemptive strikes against inflation,” Jeffrey Gundlach of DoubleLine Capital told a convention of investment advisers, speaking before the Fed announced its decision.

“They will stay low for as long as we are in this debt morass. Jobs have snapped back less and less since the late 1980s. Do you think it might have something to do with this debt experiment we’re in?”

Ten-year Treasuries are now yielding about 2 percent, having fallen from 2.40 in March on disappointing jobs and economic readings. A further rally is possible, maybe even likely, but the risk/reward proposition is hardly compelling.

Buying bonds right about now is like living on one lung; not a lot of fun, you know it won’t work forever but it beats the hell out of the alternative. It won’t be fun, frankly, because most of the gains you might get will only look good on a relative basis. It can’t work forever, at some point the U.S. will break away from a Japan track and when it does, losses on bonds will be savage. Stocks, at least theoretically, have a higher upside but come with likely high volatility and huge risks if the economy hits another air pocket.

PUSH OR PULL?

It may well be that the problems the Fed faces are simply not very amenable to the tools it has. Lowering interest rates, or keeping them extremely low, depends crucially on there being willing borrowers out there wanting to take up the loans and buy something.

Wednesday’s very poor durable goods data was not encouraging on this score, pointing to slowing manufacturing growth in coming months and presumably weak capital investment. Mortgage applications also fell, despite rates being at yet another all-time low, putting them well below their early year peaks.

A string of large regional banks reported tepid loan demand in their earnings last week, as the available supply of refinanceable mortgages dwindles and with business clients showing little inclination to invest and add jobs. Simply, you can offer loans at very low rates but unless borrowers have confidence in the future, of demand and of asset prices, it won’t do much good.

Potential borrowers are not confident about house prices. Nor are they confident about demand, especially given the likely downward slope of government spending.

With demand for loans weak, the value of deposits has fallen, a key concept that is getting little attention in the U.S.

“Deposit funding, the value of that funding is lower today than probably it has been in our careers ,” said Bruce Lee, chief credit officer of Fifth Third Bancorp, a Cincinnati, Ohio-based company that is the 23rd biggest U.S. bank by assets. here

That quote, which reflects the reality in the U.S. economy, is probably of as much significance as what the Fed said on Wednesday. The U.S. is in a balance sheet recession, one which features paying down and defaulting on debt rather than taking out more loans. That fact really limits the impact that Fed policy can have.

That means, at least for a time, that the Fed will be trapped and bond investors along with them. Despite a continued wide range of forecasts from Federal Open Market Committee members, the bottom line is that there is a strong consensus, led by Bernanke, promising no hikes until late 2014.

The problem is that the Fed is expected to do heavy lifting which really ought to be done by the legislative and executive branches. As we move further towards the “fiscal cliff” at the end of the year when tax hikes and spending cuts kick in, expect the Fed to hold its ground, rates to stay where they are and bonds, ugly as they are, to do better than stocks once again.

(James Saft is a Reuters columnist. The opinions expressed are his own)

(Editing by James Dalgleish)

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

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