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.
The same can be said for stocks. Stocks have an earnings yield, which is calculated by inverting its price to earnings ratio. So if a stock has a 20 P/E it has an earnings yield of 0.05 or 5 percent. As bond prices rise, investors demand a greater earnings yield on stocks as well. So a rising bond market can put pressure on stock prices. While companies can grow their profits in order to counteract falling prices, there is still a serious headwind facing stocks.
Thus as an investor you need to be extremely careful in the more “conventional” asset classes. Now the Fed is still buying bonds and we can continue to see bond and stock prices rise over the next few months. But I think as quantitative easing comes to an end that we can see weakness enter both bonds and stocks.
Investors are therefore encouraged to be extremely selective when buying these assets. Make sure that if you own a stock that it can grow its earnings even if interest rates are rising, and even in a weak economic environment. Furthermore, avoid stocks that are predominantly income generators such as utilities and consumer staples [e.g. Proctor & Gamble (NYSE:PG)].
You should increase your exposure to assets that have value despite the fact that they don’t have a yield—i.e. commodities. Investors should consider buying gold and silver on weakness as these assets tend to perform extremely well in a rising rate environment. While we may not have seen the bottom in these assets yet we are closer to the bottom than to the top, and they remain in a long term secular bull market.
Finally, investors should note that twice in the past the Fed has stopped quantitative easing. Each time we saw a short-lived but violent correction in stocks, and each time the Fed came back in with further quantitative easing. Any economic strength is the result of the Fed’s easy money policies, and we have seen no evidence that the Fed will be able to successfully pull back without causing a bear market and a recession. With this in mind, it is likely that the Fed will come back in with another quantitative easing program, in which case we could see any weakness in the stock market quickly reverse.
Disclosure: Ben Kramer-Miller has no position in the securities mentioned in this article.