Pain in the Markets

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By Joseph Cafariello

Thursday, November 21st, 2013

With the nations markets finally showing signs of healing after the financial crisis struck five years ago, it looks like the U.S. Federal Reserve is getting close to reducing its first aid.

While banks, businesses, and the government were haemorrhaging money during the crisis, losing vast quantities of wealth through the writedown of valueless assets, a record number of bonds flooded the marketplace in an attempt to raise money to replenish what they had lost.

The Federal Reserve decided to help corporations and the government in two ways:

firstly by buying up some of those new bonds through two massive rounds of quantitative easing, followed by the monthly purchasing of $85 billion worth of Treasuries and mortgage-backed securities which is still ongoing today, and

secondly by keeping interest rates as low as possible near zero which greatly reduced the cost of raising the money.

After the flood of bonds into the marketplace peaked in 2010, budget cuts and spending controls by government and corporations alike have reduced the need for issuing so many government and corporate bonds, finally giving the U.S. Federal Reserve a little breathing room to begin reducing some of that financial first aid.

While the economy is still not healthy enough to allow the Fed to start raising interest rates anytime soon, the long anticipated tapering of the Feds monthly purchases seems to be just around the corner on the back of a string of improving labor market reports.

But is the economy really healthy enough for stimulus reduction? Or will the markets reel in pain when the stimulus injections cease? We saw what happened this past summer when just the idea of bond tapering felled the markets to the floor the S&P 500 losing 7% in two months and the 10-Year Treasury yield nearly doubling from 1.65% to over 3% in four months. Might the Feds tapering kill the economic and housing recoveries?

There Will Be Pain

Improving spending habits and shrinking deficits are expected to reduce new bond issuances by a substantial 25%, falling by $600 billion in 2014 to $1.8 trillion, lead J.P. Morgan analyst Nikolaos Panigirtzoglou predicted to the Financial Post.

The Fed should thus have plenty of room to begin reducing its monthly purchases, which, when done, gradually should amount to a $500 billion decline in bond demand next year, Panigirtzoglou estimates.

Reducing bond demand by $500 billion and simultaneously reducing bond supply by $600 billion will result in fewer new bonds in the marketplace by $100 billion. As investors chase after fewer bonds, the impact of Fed tapering shouldnt really be as devastating to the bond market as people may believe.

The only problem is that there are fewer investors in the bond market right now as stock markets keep roaring ahead from one new all-time high to the next. Where 2013 already had a shortfall in bond demand of $140 billion, J.P. Morgan estimates next years demand to fall short by $280 billion. That means investors will be purchasing fewer bonds by some $140 billion worth.

Add it all up a shrinking supply of bonds through fewer new issuances and an even greater shrinking demand for bonds through the Feds reduced buying and investor demand shortfalls overall and we can expect a net loss in demand for bonds by $40 billion worth in 2014. This should result in slightly lower bond prices and slightly higher yields, with the 10-Year Treasury yield likely spending most of next year between 3 and 3.5%.

But there will be temporary swings to greater extremes. A long-overdue correction in equities could send investors back into bonds, driving 10-Year yields to as low as 2.5%, while the first news of Fed tapering likely in the spring could initially push rates to as high as 4% before they settle back down to the low 3% area as the higher yield makes them attractive again.

The Feds Dilemma

The potential for such high rates gives the Federal Reserve a serious headache. It cant keep buying bonds and expanding its balance sheet forever, but neither does it want to see the higher rates that would come from terminating its bond buying program. Despite some strong economic reports here and there, the Fed still sees the economic and housing recoveries as not yet strong enough to support rising interest rates on bonds and mortgages.

New Fed Chair nominee Janet Yellen explained the Feds dilemma before the Senate Banking Committee last week, as cited by Bloomberg:

Now, this is challenging. Were in unprecedented circumstances, were using policies that have never really been tried before, and were trying to explain to the public how we intend to conduct these policies. So, it is a work in progress, and sometimes miscommunication is possible.

Ward McCarthy, chief financial economist at Jefferies LLC, agreed to Bloomberg. Its been a struggle, he empathises. Theres not a whole lot to fall back on, both in terms of making decisions on how to conduct balance-sheet policy and how to communicate it. Its a new experience both in and out of the Fed.

These new experiences carry uncertainty along with them, which markets do not like. A four-year smooth sailing in equities might finally hit some choppy waters and turbulence next year. While the equities are expected to continue rising on net, given the Feds promise not to raise its benchmark interest rate any time soon, the journey to those higher levels will take us through some rough periods of adjustment to lower Fed stimulus .

Hence Yellens focus on forward guidance, her resolve to frequently and clearly communicate the Feds intentions. Being more forthcoming with its plans will go a long way toward removing uncertainty and stabilizing the markets in the process.

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A Possible New Policy Gauge

With monthly purchases soon to be out of the Feds arsenal, the central bank will have to make the most out of the one weapon it has left low benchmark interest rates. Yellen is already expected to lean toward delaying rate increases back to normal levels, pushing any rate changes to as late as 2016 or even 2017 by some estimations.

Until now, the Fed has stipulated it will keep its benchmark interest rate unchanged until the unemployment rate falls below 6.5%. But since employment figures have been robust lately averaging some 194,000 new jobs per month over the past twelve the Fed may have to find a new metric on which to gauge any interest rate hikes if it wants to keep rates low for longer.

One suggestion is to simply lower the unemployment rate threshold to 6% or even 5.5%. But James Bullard, president of the Federal Reserve Bank of St. Louis, favors using the inflation rate instead of the unemployment rate as the basis for deciding when to raise interest rates. The price-acceleration floor would be something like: so long as inflation was running below 1.5 percent the Fed wouldnt raise interest rates, Bloomberg cites Bullards September 20 th interview.

Whatever the gauge used in formulating its plans, the Feds communication of those plans will be of vital importance, so emphasised Atlanta Fed President Dennis Lockhart. He sees communication and monetary policy coming together in a policy-tool mix chosen to fit the circumstances at this particular phase of the recovery Going forward, it may be appropriate to adjust that mix, Bloomberg quotes Lockharts Nov. 12 th speech.

Investors Brace for the Shock

While the Federal Reserve undergoes changes in personnel not just with a new chairperson, but also with four other changes to its regional bank presidencies in 2014, five new voices in a 19-member body as well as undergoing adjustments in policy and strategy, investors might do well to make some adjustments to their investment strategies.

It probably wont be any different when the Fed ultimately is forced to taper, chief investment officer for fixed income at TCW Group, Tad Rivelle, cautioned to Bloomberg. What you saw in May and June of this year was simply the dress rehearsal for the main event. This is a period where you start to skinny down and shrink your risk exposure, he advised.

If markets generally experience a 10% correction every couple of years or so and we havent had one since the middle of 2011, we are certainly due for one now given 2013s 23% gains and its relentless march past previous all-time highs by some 15%. Trimming some profits from winning positions would be wise.

But keep your eye on bonds over coming months, for once the initial sell-off on the first news of tapering finally works its way through the markets, investors should find some pretty attractive yields, possibly above 3.5%. But only for a limited time, as a falling stock market will likely see a flood of money flowing out of equities and into bonds until both markets fully adjust to lower levels of Fed stimulus.

Joseph Cafariello

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