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MARKET  VIEWPOINT         2013

Stephen M. Gross, CFP®       July 2013

 

Taper Tempest

 

            With the use of a single word, “taper” the Federal Reserve (the Fed) in its May statement sent the U.S. bond market and the world-wide financial markets into major tumult.  The Fed currently buys $85 billion of U.S. Government and mortgage-back securities each month.  The U.S. bond part of these purchases is about 70% of the U.S. monthly deficit financing.  The Fed’s hint that it might taper (reduce) its monthly purchases before the end of 2013 precipitated the bond market tizzy.  The Fed’s purchases, its so called quantitative easing (QE), have been an underpinning to financial markets.  Designed to stimulate the economy, QE has mostly propped up stock, bond, and commodity prices.  Although the economy has stabilized, it has not accelerated beyond subpar growth despite over four years of QE.

 

The bond market reacted violently to this taper message, as longer-term interest rates hurled upward.  From the third week in May 2013 to the end of June 2013, interest rates on the ten year U.S. Treasury bond went from 1.6% to 2.6%, an increase of 62.5%.  Bond prices move inversely to interest rates, so bond prices fell accordingly.  World-wide bond, commodity, foreign exchange, and stock markets followed suit, shaken by the sudden jump in U.S. credit costs.  Mortgage rates in the U.S. rose as well.  Only the U.S. stock market held on, although it too fell moderately in the month of June. 

 

Despite this sharp interest rate rise in longer-term issues, the Fed has stayed committed to its zero interest rate policy (ZIRP) for short-term rates.  In fact, it unqualifiedly said that ZIRP will stay in place until 2015.  Consequently the yield curve (the difference between long-term and short-term rates) has steepened to historically high levels.  With 30 year U.S. Government bonds at over 3.5% and 3 month U.S.Treasuries at virtual zero, the difference is over 350 basis points (3.5 percentage points), a very large gap.  Except for the U.S. stock market, all of the world’s stock, bond, and commodity markets reacted negatively as well.  There were few places to hide.  Investing in U.S. stocks is not a safe haven.  With valuations stretched, which I believe they currently are, the U.S. stock market presents its own risks.

 

So where does this leave us?  My sense is that the bond market reaction to the Fed’s statement is somewhat overdone.  At some point, interest rates will have to normalize across all maturities.  When that happens is unknown, but I don’t think it is now.  We have had zero short-term interest rates for five years.  This is an anomaly and an untested experiment.  However, the Fed seems indefinitely committed to such policy until the economy returns toward fuller employment.  The Fed has much less control over longer-term rates, hence the recent sharp jump in long-term rates.  But the economy, although it has performed better in recent months, shows no signs of meaningful regeneration.  Economic growth (GDP) seems mired around 2% annually, while unemployment remains well over 7%. Employment growth has recently accelerated, averaging close to 200,000 new jobs per month.  As encouraging as the employment numbers are, they do not represent robust levels, nor do they portend any meaningful Fed credit tightening in the near future.

 

My guess is that U.S. economic growth remains somewhat tepid.  World-wide economies such as Brazil, China, and many emerging markets are slowing.  Europe remains in recession.   I think that the recent wide spread between long-term and short-term rates will not persist.  I have seen bond bear markets before (1978-81, 1994, 2005-2007). In each case, the Fed was vigorously and deliberately raising interest rates and tightening credit.  That is not the case in current circumstances.  Long-term rates may not recede to where they were in April, but I don’t believe they will continue marching upward.  In fact, long-term rates are so substantially higher than short-term rates that they begin to look compelling.  As an example, many exchange traded (ETF) and closed-end bond funds are yielding well in excess of 6%.  As for U.S. stocks, I think that high valuations plus the hefty run-up in domestic stocks this year warrant a caution sign.  Risks are high.  Further gains in stocks require a much better economic performance from the U.S. economy. 

 

Summary

Recent interest rate increases create uncertainty with respect to the ultimate end of easy money.  Consequently, stocks and bonds, as well as other markets, should experience more volatility and uncertainty from the summer months to the end of the year and beyond.  Much of what we have seen in all financial markets has resulted from monetary expansion.  Even the hint from the Fed that Fed bond purchases may slow down upset investors.  That said, I believe that there has been an overreaction in the bond market.  I feel strongly that this is not the beginning of credit tightening.  Discipline and longer-term strategies will prevail.  In the current interest risk environment, avoidance of all risk results in no return.  From my perspective, the evidence indicates that despite more volatility and risk, through prudent diversification, we can still achieve annual rates of return materially higher than the near zero return generated by riskless assets.  There just may be some shaky times along the road.

 

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