Outlook 2008: The Way to Play Bonds, Even in an Inflationary Market

Editor's Note: This is the Eighth Instalment of an Ongoing Series Highlighting the Global Investing Outlook for 2008.

By Martin Hutchinson
Contributing Editor

It's always difficult to predict a market's performance over 12 months, but this year in the bond markets it's simply impossible. The U.S. Federal Reserve will almost certainly change its monetary policy during the year, possibly more than once, and those changes will cause bond prices and yields to gyrate. Since success in the bond market in 2008 will require careful Fed-watching, I thought I'd set out some tips on what to look for.

In dropping the benchmark Federal Funds Rate from 5.25% to 4.25% in three moves since August, the Fed has backed itself into a corner. Central bank policymakers believed they had to drop interest rates because the subprime mortgage crisis had caused the global credit system to seize [although dropping rates hasn't made really fixed that problem], but the Fed didn't wait until inflation was clearly down for the count before doing so. The result: Inflation is clearly up off the canvas, and is making a nuisance of itself by doing the "Ali shuffle" as it traverses the U.S. economy.

Inflationary Fuels Abound

Since August, oil prices have soared from around $70 a barrel to a just under the $100 a barrel level. That hasn't happened because members of the Organization of Petroleum Exporting Countries (OPEC) are a bunch of global meanies [though they are], but rather because the soaring worldwide demand for oil has is pushed right up against supply, capacity is stretched very thin, and lower interest rates further stoke world demand and make the shortfall even worse.

That means the Fed may have to take some pretty nasty actions, and probably quite early this year. If oil prices continue increasing moderately - and do not feed through into "core inflation" [which excludes volatile food and energy prices, and which also is the statistic that the Fed looks at] - then all will be well. The central bank will be able to keep short-term interest rates low, which will probably keep long-term bond yields low and bond prices high.

Probably, in that case, the U.S. economy would continue to muddle forward with slow growth, but no outright recession.

That's the scenario most observers are expecting, and indeed that hope may cause the Fed to drop the Federal Funds Rate one more time, at the close of the Jan. 29-30 policymaking Federal Open Market Committee (FOMC) meeting.

The Inflation Scenario to Watch For

Even so, I have to say that this isn't the scenario I'd bet on. More likely, at some point in the year, oil and commodity prices - which already have pushed inflation well above the 4% level - will force up "core" inflation, too. At that point, two things will happen:

  • The Fed will be forced to raise short-term interest rates, to fight inflation.
  • And the long-term Treasury bond market will panic, as investors realize that - as in the 1970s - Treasury bonds suffer from their principal being eaten away by inflation, giving you the double insult of receiving interest payments that boost your tax liability, while suffering capital losses that can only be used to offset capital-gains taxes.

The bond bull's scenario - where inflation comes down naturally, and the U.S. economy suffers through only a moderate recession - seems very unlikely to me. The Fed has already eased too much for that to happen; long-term interest rates are already below the rate of inflation, and are most unlikely to go lower.

The $500 billion injected into the banking markets by the European Central Bank in mid December makes the inflationary scenario more likely. Essentially, half a year's European money supply growth has been dumped into the market in one operation. Unless the ECB forces the banks to repay all, or almost all, of that money in January, all that additional capital sloshing around in the world capital markets can do nothing but cause yet more inflation.

Most of those inflationary pressures will reach the U.S. shores, because the U.S. trade deficit is financed by the foreign purchases of bonds, transmitting much of the world money supply growth into the U.S. domestic market.

You therefore need to look at two things:

  • The monthly inflation figures - particularly the "core" figures that the Fed watches.
  • And the speeches coming out of the Fed.

If the Fed thinks an interest rate rise is necessary, it will try to prepare the market by issuing dark warnings for several weeks before it does anything. So a change in tone in Fed speeches - to one that's much more worried about inflation - is a pretty good signal that the central bank is preparing the market for a reversal in monetary policy.

The Way to Play Bonds This Year

How should you play this? Well, the downside risk for Treasury bond prices is currently much greater than the upside potential, but yields in the short (2 year to 5 year) range, the usual protection against price drops are truly lousy at around 3%. In any case, if inflation takes off, it is likely that further weakness in the dollar will result.

Thus, you should look seriously at the as the no-load T. Rowe Price International Bond Fund (RPIBX), which invests in high-quality bonds that are not denominated in U.S. dollars.

You also want to find a good way to take a "short" position in Treasury bonds, an investment that will profit when bond yields rise and prices decline. There are currently no inverse bond exchange-traded funds (ETFs), but the Rydex Juno Inverse Government Long Bond Strategy C Fund  (RYJCX) offers the same position in the form of a mutual fund. Rydex Juno is well established, having been founded in 1995, and has over $1 billion in assets; its main disadvantage is that it has a relatively high 1.3% expense ratio.

Editor's Note: Money Morning's "Outlook 2008" series last covered Alternative Energy Investments. Next up: India.

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