The markets’ response to Fed news
Stock and bond markets will move really fast and usually at unexpected moments. This is happening as I write. In essentially one month, interest rates on the 10-year Treasury have increased by over 40%, from 1.7% to 2.4% (subsequently, 10-year Treasuries have fallen in value) and markets have dropped about 4%-6%+. Most other equity markets are off by even more because of their higher risk exposure or other-country risks. Very few asset classes other than cash have been stable. This fast-moving phenomenon is why I believe it’s impossible to market time.
In a nutshell, a huge amount of bond and stock market valuation has been driven by the Federal Reserve’s quantitative easing (QE). This is essentially the Federal Reserve pumping money into the markets by purchasing Treasury and Agency bonds (and consequently pushing interest rates down quite a lot). This has been well known by most market followers and even some casual observers. What hasn’t been well known is when it would end or how and what impact it could have on markets.
Further, when interest rates rise on the risk-free 10-year bond (Treasury), many investors are inspired to sell riskier assets to purchase something less risky for the same yield. For example, say the 10-year Treasury in May was yielding 1.7% and a 10-year corporate bond is yielding 2.5% (I’m making the corporate bond number up to make my example work). A month later you can now buy the 10-year Treasury at 2.4%, so many investors will sell the 10-year corporate bond, which has more risk, and replace it with the 10-year Treasury, since it has the same yield with less risk.
The other day Bernanke hinted at ending QE earlier than planned (2014 vs. 2015) and so the markets are down sharply because the market wasn’t expecting this new information. This is how markets work: They respond quickly and sometimes violently when new, unexpected information appears.
Unfortunately, because of the influence QE had on most riskier asset pricing (inflating values), we’re now in this unwinding period where most asset classes — stocks and bonds alike — are feeling the pain because the Fed’s inflating of asset values is being projected to come to an end sooner than the market planned. When you have the government pumping up markets, you might expect volatility if and when it ends.
The market will eventually stabilize as it prices in this new information. It’s possible the market may even be overreacting here because it’s entirely possible Bernanke will not end QE. He didn’t say for sure, he just “hinted at it.” Who knows?
But going to extremes one way or the other is a bad idea. For example, owning just large-cap U.S. stocks from 1990 to 2000 was amazing, but then the market crashed dramatically and returned almost nothing from 2000 to 2010! Then over the past three years, it has been on a tear again. But do you have the patience to wait 13 to 23 years for one asset class to perform for you? Or worse, what if you invested in Japan in the 1980s? You never recovered!
It’s a bad idea to react to markets. It’s best to consider these types of events happening in advance. Portfolios are mechanisms for long-term needs; saving is a mechanism for short-term needs. So double-check to make sure you feel comfortable with your long-term and short-term needs as well. We can’t predict the future; we can only work with things we know. We seem to know that diversification, keeping costs low, monitoring tax impacts of ownership, and occasional rebalancing add value. Stick with things you know.
I hope this is a helpful perspective during markets like this.
Michael Dubis is a fee-only certified financial planner and president of Michael A. Dubis Financial Planning, LLC. He is also an adjunct lecturer at the University of Wisconsin Business School James A. Graaskamp Center for Real Estate. Mike can be reached at firstname.lastname@example.org. This article contains the opinions of the author. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products or services described in this website or that of the author’s. Mike Dubis does not guarantee the relevancy, appropriateness, or accuracy of any outside information or links. Mike Dubis does not render or offer to render personalized investment advice or financial planning advice through this medium. All references that might be made to an investment or portfolio's performance are based on historical data and one should not assume that this performance will continue in the future. THIS COMMUNICIATION MAY NOT BE USED BY YOU AS A RELIANCE OPINION WITH RESPECT TO ANY FEDERAL TAX ISSUE DISCUSSED HEREIN AND IS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED, BY YOU FOR THE PURPOSE OF AVOIDING PENALTIES THAT MAY BE IMPOSED ON YOU BY THE INTERNAL REVENUE SERVICE.
Click here to sign up for the free IB ezine – your twice-weekly resource for local business news, analysis, voices, and the names you need to know. If you are not already a subscriber to In Business magazine, be sure to sign up for our monthly print edition here.