What happens to short-term FI investors if the Fed elects not to play ball?. Tom Sowanick is CIO of Clearbrook Research, part of Clearbrook Financial, a Princeton, N.J.-based wealth-management service provider.

The bullish slope the Treasury yield curve has formed since early May has created a potentially dangerous market environment for fixed-income investors. Buy-and-hold investors should be less concerned than total-return investors, but they still need to consider yield curve location and not just yield.

The dilemma facing fixed-income investors is the absence of yield and the overbought condition of the front end of the yield curve. The three-month to two-year segment of the yield curve is now priced, on average, 75 basis points lower than the federal funds rate. It's obvious that the front end of the curve is anticipating additional rate cuts by the Federal Reserve, which would justify today's yield curve pricing.

Trick or treat

But think what might happen to investors who bought in anticipation of further rate cuts if the Fed decides not to cut rates at the end of this month. Short-term rates would likely re-price immediately to higher yield levels, creating -- at a minimum -- an opportunity loss for investors who didn't elect to sell in advance of an overvalued front end of the yield curve.

Where should investors put their cash if the front end of the curve is so overvalued? We believe investors should stay in cash until the yield curve re-prices or until after the 31 October Fed meeting.

Admittedly, parking in cash is extremely conservative. But with the Treasury bond market priced to extreme levels (in our opinion) it may be better to move to the sidelines than to keep overly valued Treasury assets. In fact, the only way that fixed-income investors can justify holding short-date Treasuries is if the Fed goes on to lower rates at a more aggressive pace than that which has already been priced into the market.

Little wonder that investment-fund managers have been calling for the Fed to keep lowering rates. Without a more aggressive Fed the total returns from short-duration funds will prove to be slight. If the Fed decides to hold rates steady there's even a chance that short-duration funds could actually suffer negative total returns.

Investors searching for yield will likely be more satisfied if they wait until after Halloween rather than locking in overvalued fixed income securities today.

Just as a 1% federal-funds rate was unsustainable, so too is the relationship between a 4.75% federal-funds rate and a 2-year Treasury note yielding 3.97%. Market bubbles are not limited solely to equities. Over-zealous investing can also roil Treasury notes and bonds.

Once investors become more at ease with the economic environment, the need to own expensive short-dated Treasuries will quickly disappear -- creating yet another class of unhappy investors. -FWR

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