Why the U.S. won't go the way of Greece
(MoneyWatch) Many investors seem to think the same fate that hit Greece will also be what happens to our bond markets. However, a deeper look at the data shows that we're not in any such danger.
The fear arises because we're racking up the same type of huge budget deficits and the Federal Reserve has an aggressive monetary policy, meaning investors believe significant inflation is on its way. In turn, this would mean higher interest rates in the future, leading investors to want to stay with short-term bonds.
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It's important to recognize that we could turn out to be the next Greece, with our bond market suffering just as badly. However, it's not even close to the certainty that many investors seem to believe.
In many cases, investors I talk to are getting these ideas from some guru, despite the lack of evidence that there are any good forecasters. In fact, when just considering interest rates, we see that actively managed bond funds have fared even worse than their actively managed stock fund counterparts in their efforts to beat simple index strategies. Also, these investors are also ones likely suffering from confirmation bias, or the tendency to favor information that confirms our already-established beliefs. However, there's another possibility that should be considered.
While the Greek bond market collapsed due to the country's fiscal problems, large budget deficits don't guarantee that interest rates and inflation will rise or that the currency will collapse. All one has to do to prove that point is to look to Japan, which has been running massive budget deficits for more than 20 years. In fact, its debt-to-GDP ratio is much worse than Greece's. While Greece's ratio is in the neighborhood of about 160 percent, Japan's is well north of 200 percent.
Yet, despite such a large deficit, Japan has actually been fighting deflation, not inflation. And interest rates are at extremely low levels. For example, the current yields on 10- and 30-year Japanese government bonds are just 0.75 percent and 1.97 percent, respectively. By comparison, U.S. rates are 1.98 and 3.18 percent, respectively. And finally, Japan's currency hasn't been too weak, but perhaps too strong.
Given the example of Japan, which has even worse fiscal problems than we do, why have so many investors ignored the possibility that the "conventional wisdom" that our rates are sure to rise might just be wrong?
Since the research shows that there are no good crystal balls when it comes to forecasting either stock or bond markets, investment decisions shouldn't be made based on some prediction, be it your own or that of some guru. Instead, the winning strategy is to adhere to a well-developed plan. In the case of bonds that means balancing the two risks of inflation and reinvestment by building a laddered portfolio with an average maturity of perhaps 10 years. And as each bond matures, just replace it with a new one at the far end of the ladder.
Money fan image courtesy of Flickr user 401(K) 2012.
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