Banking on Bonds? The Fed is using your tax dollars to make sure that doesn’t pay

Amid worries of deflation and the sluggish pace of the economic recovery, the Federal Reserve announced a second round of quantitative easing, commonly referred to as QE2. At a time when the prospects for another fiscal stimulus are dim, QE2 will pump $600 billion into the long-term treasury bond market in an effort to raise the rate of inflation and increase lending. The Fed’s attempt to jump-start the economy has sparked considerable debate about the goals and consequences of monetary policy as well as the independence of the central bank. Some prominent Republican lawmakers have even called for legislation to limit the mandate of the Federal Reserve. While the mission of the Fed has historically been to balance price stability and unemployment, today some believe it should focus solely on price stability and leave concerns about unemployment to Congress. Ironically, the last time the Federal Reserve received this much criticism was in the 1980s, when Fed officials were attacked for exactly the opposite reason- focusing too much attention on inflation while unemployment skyrocketed.

Whether you view the Fed’s actions as a risky devaluation of the dollar or a necessary injection into an ailing economy, most forecasters agree that growth will remain slow for at least the next year. The National Association for Business Economics (NABE) estimates that real GDP growth will remain around 2.6% in 2011, below the 3.5% growth rate that economists believe is needed for significant job growth. On Tuesday, the Federal Reserve is also expected to lower its predictions for next year, bringing its forecasts for growth closer in line with private economists.

Naturally, for an investor, the looming question is, “How will the Fed’s decisions affect my portfolio?” Diminished expectations and continuing uncertainty may encourage some to cling to the safety and security of bonds. Since the financial crisis began in 2008, many have siphoned their money from stocks into bonds, and according to analysts, this year alone another $250 billion has been invested into bond funds. What investors do not realize, though, is that the apparent lack of risk is misleading. While bonds may not be subject to the whimsicality of the stock market, their perpetual enemy is inflation. The Fed’s effort to boost inflation through quantitative easing is a clear signal for investors to move out of bonds. In fact, part of the purpose of QE2 is to drive treasury yields so low that people are prodded back into the stock market.

The wise investor will recognize these signs and heed the warnings. While bonds may feel safe compared to an ever volatile stock market, in this current climate, they can, in fact, be the slow, silent killers of portfolios.

For more information on bonds and to speak with your trusted guide, contact us.