On Wednesday afternoon the Federal Reserve announced that it would be tapering its bond-buying program by another $10 billion per month, which brings the total monthly purchases down to $25 billion per month. In addition it announced that it would continue to reinvest the proceeds from its bond holdings into long-term Treasuries. Finally it countered its tapering with a reassuring statement that it would continue to hold interest rates low for an extended period of time.
Markets were relatively unchanged on the day as this statement was largely expected. However, one interesting asset class to move was the bond market. Bond prices fell, and they fell hard. If you look at long-dated Treasuries through the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT), we see that they fell by 1.5 percent, which is a big move for bonds in such a short period of time (remember that people buy bonds for safety and stability). Furthermore, we saw weakness in both high yield and investment grade corporate bonds, both of which peaked in late May or early June and have since begun to trend downward. Finally, we saw weakness in stable dividend paying equities such as utilities, which tend to do poorly as bond prices fall given that their dividends appear to be less attractive.
As the Fed tapers its bond buying program, it means that there is less demand for bonds, and this has a ripple effect throughout the markets and the economy. First, while the Fed only slows down its purchases of Treasuries and mortgage backed securities, we have to keep in mind that the market values interest payments on other bonds in relation to Treasuries. So the market might be willing to accept a 6 percent annual payment on a high yield bond if the Treasury bond rate is 2.5 percent. But if the latter rate rises to, say, 4 percent, then investors will demand a greater return from high yield bonds, and they will fall until they yield 7.5 percent or so.