Although they aren't ready to give up their bearish long-term stance on bonds just yet, most financial advisers and other market participants seem to be adjusting downward their short-run expectations for higher rates and economic growth.
“We've called for the specter of inflation [for] the last year and a half, and we've been wrong,” said Saverio “Sam” Paglioni, a partner at Integer Wealth Advisors Group LLC, which manages about $230 million.
Despite the end of the second phase of quantitative easing June 30, the eurozone crisis and the potential of a catastrophic U.S. debt default, 10-year Treasury yields still hover at an ultralow 3% and short-term rates can be counted in basis points.
In a January survey of more than 1,300 advisers by Charles Schwab & Co. Inc., 64% of the respondents said that they thought inflation and T-bill rates would increase in the next six months.
It didn't happen. And it may not happen for a while.
Indeed, Bill Gross, manager of Pacific Investment Management Co. LLC's Total Return bond fund, last month reportedly increased the fund's holdings of U.S. government debt. He made headlines when he dumped Treasuries from his portfolio.
“I think people are adjusting their expectations, but I'm not sure they're adjusting their portfolios yet,” said Kathy Jones, a fixed-income strategist at the Schwab Center for Financial Research.
The immediate effect is a flight to quality, which is propping up U.S. Treasury bond prices and keeping yields low, industry observers said.
Despite all the negative headlines, U.S. Treasuries still are seen as a safe haven.
In fact, short-term T-bills briefly traded this month at negative yields — a sure sign of nervousness.
“The reason Treasury yields have stayed so low is that you have these [eurozone] fears,” said Kenneth Naehu, managing director and head of fixed income at Bel Air Investment Advisors LLC, which manages $6.5 billion for clients.
In the latest European development, spooked investors this month drove up the yield on 10-year Italian government bonds by 125 basis points over two weeks — a huge move, he said.
But a more fundamental factor in the continuance of low rates is the lack of a meaningful economic recovery, observers said.
The Federal Reserve's “extraordinary effort” to combat the
recession by adding huge amounts of liquidity to the system would normally create inflation pressures, said James Grabovac, managing director and senior portfolio manager at McDonnell Investment Management LLC, a fixed-income manager with $14.7 billion under management.
“But we haven't really seen that to any degree in this recovery, which is now two years old,” Mr. Grabovac said.
EXCESS LABOR
The large overhang of excess labor is being driven in part by the loss of manufacturing jobs, which historically provided a “quicker snapback” from recessions, Mr. Grabovac said. In addition, the housing, construction and mortgage banking sectors won't be recovering anytime soon.
As a result, “a big portion of the economy is not in position to participate in the economic recovery, and the ability for inflation to take hold is not that strong or likely,” he said,
“I think the economic activity will remain depressed, and inflation will remain low for some time,” said Lacy Hunt, chief economist at Hoisington Investment Management Co., which manages $5 billion in long-term Treasury portfolios.
Those who believe high U.S. debt levels lead to inflation are misreading economic history, he said.
“Excess indebtedness is a major millstone” that holds back economic growth, Mr. Hunt said.
Another argument for inflation and higher rates is that the government is expanding the money supply, Ms. Jones said.
But while money growth has been high, the money multiplier is low, she said.
The extra liquidity “is not going anywhere or doing anything. It has not translated into credit growth, which would drive inflation,” Ms. Jones said.
And those who expected rates to rise any day now haven't been listening to the only expert whose view really counts — Fed Chairman Ben Bernanke.
In an appearance before a congressional panel this month, he reiterated his stance that moderate economic recovery, high unemployment and subdued inflation “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”
Nevertheless, once that “extended period” is past, most advisers seem sure that inflation will return, along with bond market turmoil and higher rates.
“I don't think the rationale [for higher rates] has been wrong,” Mr. Naehu said. U.S. debt pressures eventually will force rates higher, he said.
The short-term impact is unknowable, but in the longer term, inflation will resume “if we do not stop the madness of spending,” Mr. Paglioni said.
“The question is not if rates go up. The question is, "Are you ready for higher rates?'” said Dave Pequet, president of MPI Investment Management Inc., which manages $320 million in short-term-bond strategies.
As long as rates stay low, advisers plan to play defense. Stretching for yield or lowering quality is too risky, they said.
Mr. Pequet dumped all his U.S. Treasury holdings at the beginning of 2009. Since then, his clients have been overweight in mortgage-backed and U.S. agency bonds.
He expects to shorten up the average duration of the bonds he holds, now at three years, in anticipation that the Fed has to tighten at some point.
Mr. Grabovac is concentrated on seven- to 10-year maturities where he can get some yield, thanks to a steep yield curve, and benefit from better pricing as his bonds come closer to maturity.
He's not overly concerned about Fed tightening, because he believes once the Fed does raise short rates, long-term rates might not rise much.
“In the last couple of decades, two of the three [Fed] tightenings resulted in long rates' remaining stable or coming down somewhat,” Mr. Grabovac said.
Email Dan Jamieson at [email protected]
