This was the headline story of the December 18, 2013 edition of the Wall Street Journal. That idea that central bankers would be worrying about low, not high, inflation surely comes as a shock. Many were convinced that the combination of easy monetary and fiscal policies would inevitably lead to inflation. How many warnings did you hear from forecasting gurus that inflation would be heading much higher, pulling interest rates up? For example, Peter Schiff, CEO and chief global strategist of Euro Pacific Capital, has been warning for years that hyper, not just high, inflation was the inevitable outcome. And let's not forget Bill Gross' March 2011 prediction when the "bond king" announced that PIMCO had removed government debt from its flagship fund (PTTRX), saying that bond levels had reached unsustainably low levels given the scale of government debt obligations and the Federal Reserve's quantitative easing program. At the time the 10-year Treasury was yielding about 3.6 percent.
The persistent dire warnings led to spending a large amount of my time convincing investors to ignore them and to stay the course, adhering to their well-thought-out plan. Those that did so were rewarded as inflation has defied the gurus. Over the last five years, U.S. inflation has been running at a rate of about 2 percent. For the 12 months ending November the CPI rose just 1.2 percent, well below the Fed's stated target of 2 percent. Inflation in the Eurozone has remained tame as well - November's inflation rate was just 0.9 percent. Two of the European Central banks (Sweden and Hungary) actually cut their interest rates to fight the risk of deflation. And what may come as the biggest surprise is that the inflation rate in Greece for the last 12 months was -2.9 percent. The current forecast for inflation by the European Central bank is that it will average just 1.3 percent in 2015, well below its target of 2 percent.
Despite all clarion cries about the risks of inflation, central bankers are now more worried that their economies could slide into deflation, a problem Japan has been trying to fight for over two decades now. Deflation can be a more difficult problem to fight than inflation.
All the warnings about the coming inflation led many investors to limit their bond holdings to the very shortest maturities. That caused them to miss out on the term premium that has existed for the past five years, as well as miss out on the capital gains that could have been achieved as rates fell.
Hopefully, at some point, economies will recover and interest rates will begin to rise. However, that doesn't mean that you should limit your bond holdings to the shortest maturities. The reason is that the bond market already anticipates the fact that rates are likely to rise - that's why the yield curve is so steep, with almost a 3 percent spread between the Federal Funds rate and the rate on 10-year Treasuries. Historically, that's a very steep curve. And the evidence is that term risk has been best rewarded when the curve is steep - when investors demand a large premium for taking the risk of rising rates.
This is not meant to serve as advice to buy long-term bonds. The message you to take away is that you should:
a) Ignore all forecasts because as Warren Buffett advises they tell you nothing about the market, though they tell you a lot about the person.
b) Stick with a plan for your bond portfolio. For most that means balancing the dual risks bond investors face - inflation and reinvestment fixed. You can do that by either buying an intermediate-term bond fund or building your own laddered portfolio with an average maturity of say four to five years.