Learning to ditch the training wheels

Summertime brings the joy of bike riding and, for my son, another attempt to remove the training wheels. Last summer, at 5, he made his first attempt. I got more than my daily workout running back and forth trying to get him confident enough just to keep pedaling. But he didn't, and so he fell and cried — and for the rest of the summer, the training wheels were back on. His efforts remind me of the current state of the financial markets: learning to function without the benefit of monetary-policy support. Indeed, the markets figuratively grabbed for the training wheels the moment Federal Reserve Chairman Ben S. Bernanke suggested May 22 that tapering could begin “in the next few meetings.” Increases in interest rates and volatility in financial markets followed after the June Federal Open Market Committee statement reinforced the new timing for exiting policy accommodation. The upgraded economic outlook communicated in the June FOMC minutes shifted market expectations to both a sooner and faster withdrawal of monetary-policy accommodation. That marks a significant turning point in the financial market outlook. The steady upward momentum of the “fear of missing out” stock market of only a few weeks ago has shifted to a “fear of tapering too soon” swoon some have called the “taper tantrum.” For fixed income, May and June performance represented some of the worst experienced since the financial crisis. As a result, year-to-date returns across many fixed-income categories now are negative. For example, core intermediate bond funds, the largest category of taxable fixed income, lost more than 4% in May and June, erasing what paltry returns there had been and rendering the year-to-date figures negative. Municipal bonds provided no refuge, losing 5.2% in May and June. Over this period, the rise in Treasury rates on intermediate and longer-dated maturities (nearly 100 basis points at the 10-year) exposed the vulnerability of this income- oriented asset class to such increases, due to its average longer maturity profile. That leaves the broad-asset-class returns down 3.9% for the year. Do recent rate increases portend a longer period of losses for these investments? Continued rate increases require a substantial improvement in the economic outlook. The Fed's forecasts remain highly optimistic in this regard. To the extent that this continues, the economy's performance would not justify such a recent pace of increases. That does not preclude an overshoot in bond markets — something they are highly prone to doing. However, the very action of an overshoot toward higher rates could serve to bring those increases right back down. BOLSTERED GROWTH Consider Mr. Bernanke's other comments from May: “A premature tightening of monetary policy could lead interest rates to rise temporarily.” Why temporarily? Precisely because the economy's interest-sensitive sectors are providing it critical support. In today's economy, the Fed's monetary policy support works not through the credit creation channel but the wealth creation channel: higher home and stock prices fuel wealth expansion. That leads to a return in consumer confidence manifested in a savings rate that now stands at pre-crisis levels. A lower savings rate means higher spending, providing considerable growth support. If interest rates were to increase before other segments of the economy could support the recovery, a slowdown inevitably would result. And the training wheels would go back on. Recent fixed-income returns highlight the need for more flexibility than before. The ability to raise and lower duration — a portfolio's interest rate sensitivity — across much larger bands than typically found in traditional bond mutual funds is critical. Managers also need the ability to invest across a wider array of fixed-income sectors around the world, with a wider variety of strategies. That means augmenting sector allocation and active management of interest rate risk with long and short positions, and macro hedging. It also means valuation opportunities across not only fixed income but also currencies and commodities. These approaches signal a new way to manage in today's environment: flexible fixed income. So how has my son's bike riding worked out this year? Now 6, he's ready: Off came the training wheels and he is pedaling proudly on his own. Financial markets may not be ready to ride without the Fed, but you may be able to manage your clients' fixed-income allocation by exercising a nimble, less constrained approach. Jeffrey Rosenberg is chief investment strategist for fixed income at BlackRock Inc.