The document provides an investment update for January 2011. It discusses the recent rise in 10-year U.S. Treasury yields and argues that while rates will continue to normalize, a major rise is unlikely in 2011 that could significantly hurt equities. It also critiques experts like Bernanke for being too confident in their predictions and argues many municipal defaults predicted for 2011 will likely not occur. The author maintains a below-average exposure to fixed income due to opportunities in equities but does not expect rates to rise enough to hurt the stock market in the near future.

1. Investment Update
January 2011
Shades of 1994? Previously, in early 1994, the Fed shifted from
Over the last six weeks, a hold position to a tighter stance, sending
yields on 10-year U.S. 10-year Treasury rates up 125 basis points
Treasuries rose by 100 in 48 days. That rate increase set the tone
basis points, or 1%. for one of the worst years since the almost
This move, while not 30-year bond bull market began in 1982. In
unprecedented, was fact, 1994 ended with the 10-year Treasury
surprising for several down over 8%.
reasons.
First, for much of 2010,
bond yields remained
very low, and, by early
October, yields had
dropped to just under
2.4% on fears of a
double-dip recession
and sustained
deflation. Second,
rapid rate changes
traditionally have
been accompanied
by a shift toward a
less accommodative Could a similar experience be in store for us in
monetary policy. 2011? We don’t think so. While we believe
that the multi-decade bond bull market is over,
For example, in March we do not think prospective conditions likely
2004, the Fed tightened will produce steep losses.
from a neutral/hold by
hiking the fed funds
rate, causing a 100-
basis point rise in yields.

2. Most of the upward adjustment in rates Several times last year,
reflects improving economic data, waning we cautioned against
concerns of another recession, reduced the continued strong
uncertainty following the mid-year election inflows into bond
results and an improved tone toward mutual funds because
business in general. In other words, the rate we felt that rates were
increase represents a re-normalization of at inappropriately
rates, bringing them closer to the 4% range, low levels. In 2011,
where they were in April 2010 before we we continue to
experienced a scare, albeit temporary, of recommend a below
weakened growth. average exposure to
fixed income, but our
While growth has continued to improve, recommendation
we do not think that GDP growth will be more reflects the
sufficient to generate significant near-term opportunity we see
inflationary pressure. While the tax cuts in equities than an
and unemployment extensions will further expectation of much
widen the deficit, they will not change the higher rates. We do not
budget deficit’s long-term trajectory, which think that rates will rise
remains a significant, imminent concern. significantly enough
Also, despite our seemingly well-placed to become headwinds
cynicism about the deficit reduction to equities — at least
commission report and the response since until economic growth
its release (which has been about what further accelerates and
we expected), the possibility remains that thus increases the risk
some meaningful first steps will be taken to of inflation.
address the deficit and possibly simplify tax
policy. Some degree of real progress could
help reduce upward pressure on rates. As
such, while we do expect rates to move higher
over time, we do not expect 2011 to represent
a major sea change. Investors may look at the
recent rise as a wake-up call that the trend of
ever lower long-term rates likely is behind us.

3. Advice from Experts For example, consider
In light of his role in crafting the Fed’s initial Bernanke’s comment
response to the financial crisis, we have from a July 1, 2005
great respect for Ben Bernanke. However, we CNBC interview:
have been dismayed to see him hold forth “We’ve never had a
on prime time television recently. While his decline in housing
efforts to ensure clarity and transparency prices on a nationwide
are laudable, from our experience the sound basis. What I think
bite-oriented format of TV is not well suited is more likely is that
to the complicated task of communicating house prices will slow,
central bank policy. It becomes far too maybe stabilize…. I
easy for armchair chairmen and economic don’t think it’s going
comedians — a rare breed indeed — to to drive the economy
cause embarrassment by pointing out too far from its full-
seeming or actual contradictions between employment path,
comments from prior appearances and more though.” At another
recent ones. We feel these appearances time, he expressed his
diminish the credibility of the Fed and do feeling that the
nothing to quell the considerable internal sub-prime mortgage
debate over the efficacy and advisability of crisis would remain
ongoing quantitative easing. contained. While we
know experts can fall
At one point during his recent 60 Minutes into the same traps
appearance, Chairman Bernanke responded as everyone else, we
to a question about his degree of confidence would prefer to see
that raising rates will control inflation by them preserve some
saying, “One hundred percent.” While we semblance of great
want our policymakers to be certain of their and infallible wisdom
actions, this comment was disconcerting rather than reveal their
in light of his prior expressions of confidence all-to-human shortfalls
around numerous housing-related issues. for the world to see.

4. Another example of Looking Ahead
these transgressions While some municipalities will default, we
also aired on 60 feel that far fewer than the number this
Minutes recently. An “expert” predicted will fall into such dire
analyst created quite a straits. Further, debt levels for most local and
stir when she predicted state governments are relatively low, and debt
that there would be service is a small portion of most municipal
50 to 100 significant budgets. All considered, we feel that forgoing
municipal defaults in payment on what would represent such a
2011. she predicted small savings would not solve a budget
that there would be problem and would create far greater future
50 to 100 significant financing struggles.
municipal defaults in
2011.to 100 significant While being armed with such insights
municipal defaults in does not insure immunity from difficulties,
2011. Immediately, well-prepared investors will do their
investors began selling homework and select bonds they
municipal bonds, some understand and believe will be able to
questioning whether meet their debt obligations. After all, we
they should own any are again able to find bonds we think are
such bonds at all. In stable at yields that compare very favorably
reality, the precarious to Treasuries and other taxable bonds. While
state of municipal caution is warranted and some areas should
finances is not a be avoided, outright selling does not appear
new story and is well appropriate.
understood by most
professional investors in
this space.
Christopher Sheldon
Director of Investment Strategy
© 2010 The Bank of New York Mellon Corporation.