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Oct 3
Bonds And Diversification
Paul Volker took over the Fed in 1979.  He decided that he would no longer target interest rates and that he would break the hold of stagflation that had gripped the US economy for a few years.  Some of you may remember the misery index, the inflation rate added to the unemployment rate.

The Fed stepped hard on the brakes and interest rates began to rise.  And they rose and rose and rose until the Prime Rate was above 21.5% and Fed Funds were above 14% in 1981.  We then had 20 plus years of falling interest rates.  This was the biggest bull market for bonds in US history.  Remember, as interest rates fall, the price of bonds rises.

During the 1990s stocks and bonds rose and fell together and bonds could not fulfill their role in diversifying a portfolio. 
Bonds no longer have the tailwind of continuously falling interest rates.  They should resume their linkage with business cycles.  But they have not fully done so yet.

The reason is that foreign central banks have found it expedient to invest hundreds of billions of dollars in the US bond market.  The continued demand has kept bond prices high for much longer than the current stage of the business cycle would suggest.  No one is quite sure what will trigger them to stop financing our trade deficit but there is little doubt that someday it will end. 

Until then, bonds will provide some diversification but not as much as they should. 

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