Don’t Get Burned By Bonds

With stocks on a tear and bond yields on the rise, it might be tempting to dip a toe back into the bond market. But with the bond market likely just starting to heat up, that toe might get burnt.

I’ll get to my reasoning in a moment, but if you’re tempted to invest in bond market at this point, I would stay away from both short-term and long-term issues since both are likely to see some whipsaws in the coming months. Instead, I’d steer a middle course with intermediate-term funds with maturities between 3 to 5 years, like the Vanguard Intermediate-Term Bond ETF (NYSE: BIV). I’d especially be looking at Treasury Inflation-Protected Securities (TIPS) as a hedge against rising inflation, using funds like iShares TIPS Bond (NYSE: TIP). TIPS haven’t been getting much love lately because there just hasn’t been much inflation to speak of, but it looks like it’s probably coming.

A major force driving bond yields higher is the prospect of the Fed bumping interest rates at their meeting later this month. Unemployment remains low, housing remains strong and revised numbers show that U.S. GDP rose 3.2% in the third quarter, the biggest bump in two years. Add in the increasingly hawkish chatter from the Fed over the past month or so and a December hike seems inevitable.

All those factors are stoking inflation worries again, especially since there’s been a pick-up in consumer spending. President-elect Trump is also talking about massive tax cuts and a boost to both infrastructure and defense spending, the very definition of a fiscal stimulus.

That’s good news for stocks, hence the rally, and potentially good news for income investors who have basically been priced out of the bond market. But there’s still a lot that could go wrong.

For one thing, President or not, Donald Trump won’t be setting the federal budget. He can propose one and create draft legislation to send to the House of Representatives but, ultimately, he either signs whatever budget they pass or he doesn’t. I suspect that even with a friendly Congress, when it comes to budgetary issues it still won’t be easy to add to the deficit, which such a plan certainly would.

The other potential problem is that the economy is actually in good shape—contrary to Trump’s election rhetoric. Throwing kindling on an economy that’s heating up, if not exactly blazing, and you end up with an inflationary conflagration. That’s especially true now that oil prices look to start moving higher.

So while bond yields are becoming increasingly tempting, I wouldn’t take the bait. We’re still more than a month away from Trump taking office and his plans could change between now and then. There’s also a good chance that even if Congress doesn’t obstruct Trump’s plans it’s likely to at least scale back spending.

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