Fed moves on interest rates have been jolt to bonds

Sometimes, when an asset class is showing its worst performance in a long time it might be a sign that the tide is turning. At least that is what optimistic bond managers believe these days.

The first half of this year was the most punishing for corporate bonds in at least eight years. The Lehman Brothers U.S. Aggregate index, a general measure of bond movement, fell 0.7 percent as investors sold off in the wake of a relentless string of interest rate hikes by the Federal Reserve and continued concern on inflation from high oil and other commodity prices.

Now some managers believe it’s possible the Federal Reserve might pause in its rate-hiking activities when it meets on Tuesday. Others believe at least one more quarter-point upward boost lies ahead.

The Fed has four more meetings left before the end of the year and markets are pricing in that the Fed will pause. But no one knows for sure, of course, exactly when the pause will occur. Generally, most are adopting a wait-and-see attitude.

Once the Fed does pause, bonds – whose price reacts inversely to interest rate movements – are likely to benefit.

As it is, the Fed’s rate hikes in the first half of the year – bringing to 17 the number of quarter-point increases since the Fed began tightening – sent bonds tumbling and was a major surprise to the markets. At the beginning of the year the markets were anticipating the Fed would stop the rate hikes at 4.75 percent (the federal funds rate now stands at 5.25 percent).

Investors continually try to look ahead, anticipating events and trying to buy in before they take place. We can expect, therefore, that bonds might start gaining as soon as investors have a greater degree of confidence that the end to this rate-tightening cycle is on the horizon.

Behind the maneuvering is a dilemma facing Federal Reserve Board Chairman Ben Bernanke. It’s a dilemma that many of his predecessors in office have faced at this point in the economic cycle.

The essence of his dilemma is that Fed actions have an impact on the economy only several months down the road. It’s like driving a car when you have to turn the steering wheel some distance before a turn in the road that you cannot see. Although the sign warns you a turn lies ahead, it does not indicate how sharp it is. Turn too sharply now and you might swerve off the road when you reach the bend. Don’t turn enough and you will also leave the road.

Not only that, but you need to apply the brakes to just the right degree to retain control.

You need to do all this some time before you reach the bend in the road as the car will respond to your instructions only when it reaches the bend. By then it will be too late to change your actions.

Added to this is the impact of steering and braking actions you have taken earlier that are being felt now.

Should the Fed hike interest rates too high now, in five to seven months the economy might dip into recession. Stop raising them and in that time inflation might start raging out of control. By the time the impact is felt, it will be too late to go back and change course.

Bernanke has to find the right combination to keep the economy on track, remaining aware that some of the impact of the previous 17 rate hikes are still rippling through the economy. He also has to watch the impact of oil and housing prices, which add to the effect of interest rates in slowing the economy.

At Russell, our view is that the Fed has already appropriately applied the brakes and indeed turned the wheel enough to maneuver the economy on to a stable course. The increased cost of borrowing money as a result of Fed hikes, we believe, is enough to contain inflation. Rate hikes by other central bankers around the globe should also help dampen growth.

Although money markets, in some cases now yielding above 5 percent, have produced better returns than bonds in the last few months, that situation might reverse should bonds stage a comeback.

Additionally, history shows that after the Fed’s last hike in a tightening cycle, bonds tend to outperform money markets. That happened, for example, in 1994 and in 2000.

As always, investors should remain fully invested and diversified among stocks and bonds and should avoid acting in light of what has happened rather than what might happen in the months and years ahead. If you have let your bond investments slip below the percentage that you normally devote to them, now might be a good time to rebalance back to the original percentages that you established for stocks and bonds in your portfolio.