Reduce Bond Exposure

The Fed's latest move to lower short-term rates leaves bond investors with little room for error

By Joseph Lisantib

To no one's surprise, the Federal Open Market Committee lowered its target for the Fed funds rate, what banks charge each other for overnight loans, by 25 basis points to 1%. The FOMC again cited the worry of "an unwelcome substantial fall in inflation," which is Fedspeak for deflation, as the principal reason for the move.

We don't see deflation as a major worry -- ask anyone paying college tuition or health care bills if prices are falling -- and view the Fed's action as yet another attempt to bolster a still anemic economy. Combined with the fiscal stimulus of the recent tax cut, lower rates should lead to a strengthening of the U.S. economy later this year.

Therein lies the problem for investors in bonds. Even though the Fed is signaling that it intends to keep rates low, a stronger economy means increased risk of inflation, which would pressure bond prices. We don't presume to know when the markets will perceive a whiff of inflation. It could be well into next year before prices begin to rise at a quicker pace. Or it could be sooner.

Whenever it happens, bond prices will tank. For that reason, we advise taking 5% out of the allocation to bonds. That still leaves a recommendation of 10% in debt securities. We suggest that your remaining assets in the category be limited to short-term instruments or longer-term Treasuries and high-quality municipals and corporates that you plan to hold to maturity.

We continue to advise keeping 65% of assets in equities as we expect stocks to trend higher by yearend. Why didn't we move the 5% from bonds into stocks rather than cash, which currently yields almost nothing?

The stock market has moved sharply higher since mid-March. We expect it will be in a trading range for a while, and it could dip a bit in the traditionally weak third quarter. Hold reserves to deploy then.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook

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