Fixed income investors have faced a number of potential threats this year ...

A projected US budget deficit of $1.6 trillion this fiscal year¹ ...

The US government out of spending power — running into the statutory debt ceiling of $14.3 trillion in May² ...

A downgrade of the US government’s sovereign credit rating outlook by analysts at Standard & Poor’s!³

Against this backdrop of negative news, you might expect Treasury bonds to follow in the footsteps of Greece and the other debt-strapped Eurozone PIIGS — with bond yields surging higher as prices tumble. But you’d be wrong.

Confounding investor expectations, longer-term US Treasury securities have been among the best-performing asset classes of 2011. The Bloomberg US Government 10+ Year Bond Index’s total return is 4.9 percent year-to-date. By comparison, the S&P 500 Index is up just 1.9 percent in 2011, after the recent pullback, while the MSCI Emerging Market Index is down –0.8 percent.⁴

Treasury bonds have rallied this year as a string of downbeat data on the US economy has trumped, at least for now, uncertainties about the government debt limit, growing budget deficits and the fast-approaching end of QE2 in a few weeks.

Bond investors should enjoy these gains while they last because today’s ultra-low Treasury yields don’t offer much appreciation potential over the long run.

In 2008, fearing a deflationary spiral in the aftermath of the financial crisis, the Federal Reserve pulled out all the stops to rescue the financial system from the brink of collapse, revive the US economy and get credit markets moving again.

But as a by-product of these efforts, the Fed inflated its balance sheet by buying more than $2 trillion of troubled assets at the same time Washington ramped up deficit spending with multiple rounds of fiscal stimulus.

Today — more than two years after the recession officially ended — the Fed continues on a path of easy monetary policy while Congress bickers over yet another increase in the statutory debt limit.

What we’re experiencing right now is a tug-of-war between the opposing forces of deflation and inflation. And the outcome of this struggle could have major implications for your investment portfolio ... especially if you’re a fixed income investor.

Has the Fed Missed the Inflation Boat?

Investors are right to be concerned that if the Fed isn’t quick enough to reign in its easy-money policies and withdraw excess liquidity from the system, it runs the risk of igniting inflation expectations.

True, inflation today appears subdued with the consumer price index (CPI) expanding just 3.2 percent year-over-year.⁵

That’s below the historic rate of CPI inflation, which has averaged 4.1 percent since 1960. But other inflation measures are accelerating faster.⁶

For instance, the May producer price index (PPI) reported yesterday shows wholesale prices accelerating at a 7.3 percent annual rate. That’s more than double the rate of producer price inflation in January 2011!⁷

Rising input costs, including food and energy prices, at the producer level are the main culprit. This could foreshadow higher consumer prices ahead. That’s because rising input costs tend to impact producer prices first, and then, if they remain elevated, inevitably show up in consumer prices.

Unfortunately, the Fed tends to focus on the more popular CPI than the PPI. In fact, the Fed prefers the core CPI, which strips out volatile food and energy costs. This can be misleading, because these commodity input costs have been mostly trending higher lately.

Inflation Isn’t a Problem ... Until It Is

By the time inflation accelerates unexpectedly, it may be too late. In other words, once the Fed falls behind the curve of inflation expectations, it could be very difficult to slow it down.

With historically low yields on traditional, fixed income securities, investors today have limited choices. We discussed this dilemma in a previous issue of the Banyan Market Letter (See 3 Steps to Consider in a Shifting Interest Rate Climate).

In our view, interest rates and inflation are bound to move higher in the years ahead. It is only a question of when. Remember, bond prices typically move opposite interest rates and inflation.

If you’re holding a portfolio of longer-term bonds during a climate of rising rates, you could experience a significant loss in the market value as interest rates move higher.

Right now, there are a number of reasons to be worried about escalating interest rates and inflation. We feel that, while the timing is uncertain, the threat of inflation should be taken seriously.

Who Will Step Up to Buy Treasuries?

The Federal Reserve’s $600 billion bond-buying binge (QE2) comes to an end this month. It’s difficult to say exactly how much of an impact the Fed’s quantitative easing has had on interest rates. But the reality is that one of the biggest recent buyers of Treasury bonds will be out of the picture in just two more weeks.

It’s been estimated that Federal Reserve purchases under QE2 swallowed up about 85 percent of net US Treasury issuance over the past eight months.⁸

With soaring budget deficits, new Treasury bond issues are expected to remain elevated. But once QE2 runs out, the $64,000 question is: Who will step up in place of the Fed as the buyer of last resort for government bonds?

After the Fed, foreign investors were the next biggest buyers of US Treasury securities last year. To avoid higher Treasury yields post-QE2, overseas fixed income investors may really need to step up to the plate after June.⁹

At the very least, we could see a pick-up in bond market volatility.

Wealth Transfer via Inflation

We see fresh headlines about the Eurozone debt crisis nearly every day, and it’s not too hard to imagine a worst-case scenario playing out here.

Greek, Portuguese and Irish 10-year government bond yields are climbing to record highs as EU finance ministers quibble over details of a new bailout package for Greece.

The benchmark 10-year Greek government bond now yields 17.5 percent as of yesterday, while prices plunged nearly 40 percent in value over the past year as the country’s debt woes worsened.¹⁰

Granted, the US isn’t in the same boat as Greece or the other PIIGS (at least not yet anyway), but difficult fiscal choices need to be made in the US during the months and years ahead to avoid a similar fate. Fixed income investors should be watching developments closely.

The world’s largest bond fund manager, Bill Gross of PIMCO, made headlines earlier this year when he dumped all Treasury securities from his portfolio. He simply didn’t see much value in the Treasury market. It’s not uncommon for large institutions to periodically rotate out of certain types of bonds when they appear overpriced, then repurchase them down the road at more attractive levels.

In retrospect, Gross’ sales proved a bit premature, as long-term Treasuries have rebounded in recent months. But in a recent commentary, he wrote, “Rather than outright default, many countries attempt rather successfully to keep nominal interest rates lower than would otherwise prevail.” He goes on to warn that the end result is “a transfer of wealth from savers to borrowers.”¹¹

At times, the last desperate act for governments that have taken on too much debt is to engineer inflation ... devaluing the real value of the debt in the process ... and easing the burden of repayment.

Today, we have a tug-of-war between opposing forces and it could have significant implications for your fixed income investments.

From the US Treasury’s viewpoint, it wants rates to remain low as long as possible because it is footing the bill for interest payments on all this debt. On the other hand, the threat of higher inflation may force the bond market’s hand before long if investors demand higher interest rates to compensate for inflation.

In any case, we do not see the historically low Treasury yields offered right now providing a fair trade-off for the risk an investor must take to hold long-term bonds.

Instead, select global markets that are not under the same fiscal pressures we are domestically may offer many investors better fixed income opportunities right now. At Banyan Partners, we can help you uncover hidden values and show you how to earn higher yields. And with QE2 coming to an end soon, now may be the right time to take another look at your fixed income portfolio.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

P.S. Are you worried about rising rates, inflation and the impact this could have on your fixed income portfolio? Go here now for your free Rising Interest Rate Tool Kit including a complimentary copy of our just-published special report.

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The opinions expressed in this newsletter are subject to change without notice and do not represent a complete analysis of every material fact with respect to the economy, industry or investment opportunity mentioned in this report. This information has been prepared solely for information purposes and is not a solicitation or an offer to buy a security, instrument, or to participate in any trading strategy.

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¹ Bloomberg: Treasury Bill Rates at Almost Record Low, 5/16/11
² Ibid.
³ Standard & Poor’s Ratings Direct, 4/18/11
⁴ Bloomberg market data, 6/13/11
⁵ Bureau of Labor Statistics: Consumer Price Index – April 2011, 5/13/11
⁶ Ibid.
⁷ Bureau of Labor Statistics: Producer Price Indexes – May 2011, 6/14/11
⁸ Morgan Stanley Global Economic Forum, 6/2/11
⁹ Federal Reserve Flow of Funds, 6/9/11
¹⁰ Bloomberg market data, 6/14/11
¹¹ Pimco Investment Outlook, June 2011