The Market Gets a Wakeup Call

As the second quarter came to an end, investors found themselves grappling with two perplexing questions: 1) when would the Fed begin to slow its program of quantitative easing (the so-called “tapering” of bond pur­chases), and 2) how quickly would the Fed reverse its policy of monetary largesse?

These ques­tions had been discussed in hypo­thetical terms for several months, but they were usually greeted with barely sup­pressed yawns by most investors. On June 19th, the conversation became much more earnest. In a press conference following June’s bi-monthly meeting of the Federal Reserve Open Market Committee (FOMC), Fed Chairman Ben Bernanke announced that tapering could begin as soon as year-end and bond purchases could cease by mid-2014. Though he tried to couch his message in terms most reassuring, the market’s reaction was dramatic.

In the four days following Bernanke’s statement, the S&P 500 shed nearly 5 percent and interest rates on 5- and 10-year Treasury notes jumped 41 and 37 basis points, respectively. It was the largest 4-day jump in yields since May 2009 and the largest 4-day percentage drop in stocks since November 2011. Other asset classes showed similar stress in the second quarter. Gold and other precious metals suffered the greatest losses, though their problems had little to do with Bernanke and the Fed.

As we think about the potential impact of changes in Fed policy, we should remember that the primary effect of the Fed’s bond buying program was to artificially suppress the level of interest rates on intermediate maturity bonds. (Its impact on the money supply was minimal, a conclusion suggested by the fact that most of the reserves created by the bond purchases have remained on the Fed’s balance sheet as “excess reserves.”)

With this in mind, it should not be too sur­prising that the biggest bang in the bond mar­ket from Bernanke’s statement came in 5 to 10 year maturities as yields jumped more than 40 basis points. We expect further rate increases and a steeper yield curve in the post-QE world. The impact on stocks is a different matter entirely. To understand the likely impact on the stock market, we need to look more closely at the relationship between interest rate increases and stock market returns.

correlations+between+weekly+stock+returns+and+interest+rate+movements.png

Conventional wisdom says that stock prices fall when interest rates rise, but, as we can see in this chart by our friends at JP Morgan, that isn’t always the case.

The graph plots the correlation between rate changes in 10-year Treasury yields and subse­quent changes in the stock market. When yields are below 5 percent, there is a positive correlation, meaning that stock prices rise as interest rates rise. As interest rates rise above 5 percent, the correlation turns nega­tive and rising yields lead to lower stock prices.

This relationship makes sense when you think about why interest rates would be low (a sluggish economy and low inflation) but rising (increasing evidence of economic recovery.) These are the same conditions identified by Bernanke as the drivers of change in Fed policy. In his prepared statement on June 19th he said:

I would like to emphasize…that our policy is in no way predetermined and will depend on the incoming data and the evolution of the outlook, as well as on the cumulative progress toward our objectives. If conditions improve faster than expected, the pace of asset purchases could be reduced somewhat more quickly. If the outlook becomes less favorable,…reductions in the pace could be delayed. (Transcript of Chairman Bernanke’s Press Conference, 19 June 2013)

In other words, Fed policy is going to be sensitive to developments in the underlying economy. As the economy improves enough to prompt a reduction in the Fed’s accommodative stance, those same economic improvements will be supportive of equity prices—at least to a point.

 As you know, we have been concerned about the possibility of rising rates for several months and we are taking specific actions to manage our clients’ exposure to market volatility. One technique is to incorporate low volatility equity funds and index-linked CDs into the core holdings of a portfolio. If you have any questions about how these investments might apply to you or how changes in Fed policy might affect your particular situation, please feel free to give us a call. As always, we look forward to helping you gain greater clarity and confidence in your financial future.