The End of Easy Money

Still, this is no time for complacency. Interest-rate cycles usually last years, and don't change overnight. Even so, it's becoming apparent that we're in the midst of an historic shift from a long period of rising short-term interest rates to one of flat to declining rates. While I've mentioned some of the effects this may have on stocks, it's also likely to have an impact on the fixed-income portion of your portfolio.

Lately, it's been pretty easy to be a fixed-income investor. As I advocated in several columns, all you had to do was put cash in a money-market fund and collect ever-rising yields, while putting your bond allocation into one- to three-year certificates of deposit. With the yield curve nearly flat, and even inverted at times, you could capture maximum returns of close to 5% with minimal risk. (Certificates of deposit are FDIC-insured and their short duration protects them from significant loss of principal if rates rise.) True, this approach wasn't earning double-digit returns, nor was it fodder for exciting locker room or dinner party conversation. But you sure didn't lose any sleep.

It also turns out this was a good strategy this year, one of those relatively rare periods when cash outperformed longer-term bonds. So far in 2006, cash equivalents earned 2.9%, while 10-year Treasurys lost 1%. But don't expect this to last much longer. Because it's virtually risk-free, cash is historically the worst place to park your assets. It hasn't kept pace with inflation over time and lags far behind every other asset class. Whenever the Fed begins cutting rates, money fund rates will start to drop. That's often when stock markets take off and longer-term bonds rally.

I'm not saying you need to rush to move out of money-market positions. Because of the lag time between Fed actions and the marketplace, money-market funds are just now reaching their peak from the recent tightening cycle. Last week, money-market funds were yielding an impressive 3.36%. A three-month Treasury note was at 5.09% and the six-month was at 5.2%, higher than any of the longer-maturity Treasurys. So enjoy these yields while they last — but be prepared to abandon them in the not-too-distant future. Exactly when that time will come is impossible to say, but no later than the Fed's first rate cut, which some are predicting will come early next year. I plan to start shifting some of my money-fund assets into six-month and one-year CDs very soon, in order to lock in those high near-cash rates for a little while longer.

The one-year CDs I bought last year are also nearing maturity. My strategy last year was to buy a mix of one-, two-, and three-year CDs to take advantage of the flat yield curve with minimal maturity risk. Under that approach, I would simply have taken the proceeds and bought another three-year CD, so my CDs would continue to mature every year over a three-year cycle. But when short-term rates start to drop, does this approach still make sense?

That depends on how you think the yield curve will react. As the Fed was increasing short-term rates, long-term rates barely budged, an anomaly that puzzled former Fed chairman Alan Greenspan. (Ordinarily, long-term rates would have risen, keeping the yield curve sloping upwards.) Does this mean that short- and long-term rates have become decoupled, and that falling short-term rates won't have their usual effect on long-term rates?

So far that hasn't happened. As expectations have grown that the Fed has stopped raising rates, longer-term Treasurys have rallied, with their yields dropping below 5%. (The 10-year Treasury was at 4.84% last week.) The yield curve has again become slightly inverted, traditionally a harbinger of a slower economy. Under these circumstances, it's hard to imagine longer-term rates rising significantly anytime soon, unless inflation proves much stronger and persistent than expected. As a result, investors have started moving a little further out on the yield curve to lock in current rates, with the five-year Treasury now yielding 4.78%, slightly less than the two-year or the 10-year. You may find it prudent to do the same, though I remain comfortable with a three-year time period. I still can't get very excited over yields under 5% on a 10-year bond.

With the economy slowing and the real-estate market faltering, I wouldn't seek higher yields by taking on more risk. I would continue to avoid junk bonds, which have had a decent — though not spectacular — year, with total returns in the 5% range. The spread between riskier junk bond and U.S. Treasurys continues to be historically narrow, and should widen if a slowing economy causes some defaults. This would hurt overall junk-bond returns. REITs, too, have defied expectations, in many cases racking up double-digit returns over the past year. But many markets already show signs of a downturn. With current yields in most cases lower than the yield on cash or treasuries, investors have to count on continued capital appreciation, which strikes me as increasingly unlikely.

For now, some modest tweaking is probably all that's necessary. Should the stock market indexes fall below my latest buying target (1938 on the Nasdaq), I'd increase my allocation to stocks, and reduce the cash and fixed-income portions of my portfolio. We've just come through an extended period when bonds and cash have outperformed their historical norms. But nothing goes on forever. History suggests that stocks will sooner or later regain their status as the best-performing asset, and I want to be fully invested when they do.