FM: Many analysts feel that the extraordinary monetary accommodations of the last several years is setting the U.S. up for massive inflation. Do you agree?
PF: It is certainly a risk but it is a risk the Fed is running reasonably. I have been telling clients for some time that inflation is coming later than you think. Given how median income in the United States has been falling for three years, given the weakness in the economy here and the European economy, you can see a slowdown happening now in China and East Asia; it doesn't seem to me that inflation is the risk right under our noses for the coming year. It is something that you can worry about further out. Two things have to happen for inflation to really become a problem that would upset investors. The first is that the economy would have to pick up a lot of speed. It is very hard for me to see inflation really getting in the area that would be concerning without the economy getting much stronger and then the Fed would have to not tighten policy in time. Those two things could happen but it would be a pretty good outcome to see the economy pick up speed and then the central banks and the Fed in particular. Given the errors we lived through in the late 1970s, the Fed would likely tighten in a timely manner. It is clearly a risk but I don't think [higher inflation] is the central expectation that I have for the coming year but we will have to see. If the economy does do better, I can see inflation being a problem a little further out.
FM: But we have seen price inflation. Is there some way for investors to prepare?
PF: Obviously there are inflation-linked securities; TIPs (Treasury Inflation-Protected Securities) here, linkers (Inflation-indexed bonds) around the world, the various commodity plays. Clearly people have made some money in the gold market and other commodity markets over the last couple of years. If you want to look at the TIPs market as a hedge against inflation, investors should be very clear on why they are buying TIPs. You could imagine them being a play on real rates, in which case you hold them hoping real rates go lower and you pick it up on appreciation. If you are buying TIPs as a hedge against inflation, then you should expect real rates to back up before the inflation premium kicks in and you get your inflation insurance. Some people are afraid that TIPs are too expensive now that rates have rallied so far; well they are not going to be expensive if what you are worried about is high inflation in the future. That is the easiest way to hedge yourself but you have to be clear on why you are buying them.
FM: We are in the midst of a 30-year-plus bull market in Treasuries. Will this end any time soon?
PF: We are nearing the end of the rally that can unfold. Some people therefore think the next move is 30 years of interest rates backing up; I don't know that is the most likely outcome. If you look at 100 years of data, interest rates have been pretty low so the question is what are we mean-reverting to? If we are going to mean-revert back up to the high inflation of the late-70s/early-80s, then we are going to have 30 years of backup; if we mean-revert to the last 100 years of data, interest rates are going to stay right around 2 or 3% for a while.
That is the real challenge for investors. The Fed anchoring expectations for rates staying low tells us a fair bit about what is going to happen for the next year or so until the Fed gives us different expectations.
FM: Do you expect a change in either long- or short-term rates in 2012?
PF: Not in short-term rates, the Fed has been pretty clear, unless the economy picks up steam dramatically. Ten-year U.S. rates I can see trading in the low 2% range for most of the year. They might back up if the economy picks up, but the Fed having anchored short rate expectations is going to be a powerful force keeping rates somewhere near the 2-3% range.
FM: What is the best investment in the fixed income arena? The safest?
PF: If you are focused on safety, you are going to look at Treasuries. A very reasonable investment strategy for most investors is to look at some of the more secure spread sectors like municipal securities, like investment grade credit and even like our high-yield market, which is nowhere near as risky as it was in the 1980s. Companies are not as highly geared as they were then. A diversified portfolio of municipal securities, investment grade credit, some high-yield, could be a very sensible portfolio, picking up a little spread in this environment where I don't expect rates to back up very much over the coming year. They may back up a little but if you've bought some of these spread products you are going to have picked up enough income to overcome that.