For some five years now, monetary stimulus from the U.S. Federal Reserve has upset the normal risk : reward gage in both the equity and bond markets. Across two Q.E. measures and the more recent monthly bond purchasing program, investors have adjusted their portfolios to a low risk climate.
But look out below. The Fed is about to scale down its stimulus, starting with reduced monthly bond purchases until about mid-2014, to be followed by rising interest rates from about 2015 to 2018 or so. As this slowly increases risk, investors are now looking to be compensated with increased reward.
Jeffrey Gundlach, chief executive and chief investment officer of Los Angeles based DoubleLine Capital, managing some $57 billion mostly in fixed income instruments, believes the beginning of stimulus tapering is not the end of bonds. In fact, he sees the Fed’s move as a great buying opportunity for locking in attractive yields not seen in over two years.
But is he right? Are the higher rewards in bonds and U.S. Treasuries worth the higher risk from reduced Fed support? Or will you find better rewards for your risk elsewhere?
The Risks Ahead
To identify the better risk : reward vehicles, we need to first assess where the added risk is going to be.
The U.S. Federal Reserve wants to eliminate its monthly bond buying program, and an announcement outlining such a plan will almost definitely be delivered on the 18th of this month, at the close of the FOMC’s two-day meeting. We don’t know when monthly bond buying reductions will begin, but they will likely start before the end of this year.
After the monthly bond buying program is terminated – probably by mid-2014 – the Fed will then begin slowly raising interest rates from about 2015 to about 2018.
Risk will increase clear across the board, from equities to bonds, since both markets benefited from all these years of stimulus. For the ever increasing risk, investors are and will be demanding an ever increasing reward. Hence, in a CNBC interview, Gundlach speculated “the yield on the 10-year could go to 3.10 percent by year end”.
Gundlach postulated that yields should stop there, drawing “comparisons to how rates rose in 1994. Rates spiked following a sell-off (not unlike the sell-off in May-June), only to slow down for a few months, and then gradually went higher due to a lack of interest. He thinks that’s what’s happening now.”
If that same pattern is repeated this time around, we could expect bond yields to stop climbing soon, stabilize, and maybe even come back down just a little for “a few months”. After all, at 3% on the 10-year, the reward would be high enough to compensate investors for the higher risk, and a slow trickle back into the bond market would stabilize bonds.
But that all depends on how much risk investors believe bond tapering will introduce. Five years of stimulus have so distorted the values of both the equity and bond markets that we have lost track of where those markets should really be. We are entering a phase of discovery where all investors – institutional and retail – are at the mercy of the collective.
Much will depend on economic reports over the next two or three months. If those reports are weak, coupled with reduced stimulus, the investors will perceive additional risk in the marketplace and will demand additional reward, pushing Treasury yields much higher and equities much lower.
“If the 10-year goes to 3.50,” Reuters quotes Gundlach, “I think you’re going to see serious downward movements in risk assets, and that would stop the interest rate rise in its tracks.”
“Serious Downward Movements”
If the risk introduced by bond tapering is perceived by the markets to be low, Gundlach advises to invest in Treasuries and mortgage REITs, since there would be little downside to prices relative to their high yields.
But if the markets assess the added risk to be high, then those “serious downward movements in risk assets” mentioned by Gundlach above would severely hurt REITs, bond funds with long-term fixed-rate holdings, and small to mid cap companies with high debt burdens.
REITs: Mortgage REITs would not be as good a deal in this scenario, because as the Wall Street Journaldescribes, mortgage REITs “borrow money using short-term debt and use the funds to buy longer-term mortgage securities, earning the spread between the rates.”
If the risk being added by reduced stimulus is perceived to be high, a REIT’s long-term assets would suffer greatly, while its short-term liabilities would benefit little. Sure, they will earn higher interest on newly acquired long-term assets, but the drop in value of existing assets would cut into those gains.
Bonds: For the amount of risk being added by stimulus reduction, you would earn better rewards by investing in variable rate bond funds holding shorter-duration assets, such as Eaton Vance Senior Floating-Rate Fund (NYSE: EFR) currently yielding 6.15%, BlackRock Floating Rate Income Strategies Fund Inc. (NYSE: FRA) yielding 6.06%, and Nuveen Floating Rate Income Fund (NYSE: JFR) yielding 6.83%.
Equities: In the equities market, the increased risk brought by falling stimulus and rising yields would hurt small to mid cap corporations more than the large caps, as smaller companies typically have low cash flow and high debt, and the higher interest on those debts will leave less cash on hand to growth their businesses.
Foreign markets: The above applies to investing in foreign countries as well, where a current account surplus is to governments what positive cash flow is to corporations. Rising yields and the eventual raising of interest rates down the road will strengthen the USD and weaken emerging market currencies. Countries with current account surpluses will have all the cash they need to keep expanding their economies, while those with account deficits will slowly grind to a halt as higher interest payments leave less money for growth and expansion.
For this reason, Gundlach is still heavily invested in Russia, whose annual current account surplus of U.S. $198 billion ranks third highest in the world thanks to huge oil revenues, bettered only by Germany with a surplus of $219 billion and Saudi Arabia at $252 billion (based on 2011 data).
Join Wealth Daily today for FREE. We”ll keep you on top of all the hottest investment ideas before they hit Wall Street. Become a member today, and get our latest free report: “The Next Gold Rush: Three Easy Gold Investments fo 2020”
It contains full details on something incredibly important that”s unfolding and affecting how gold is classified as an investment..
After getting your report, you’ll begin receiving the Wealth Daily e-Letter, delivered to your inbox daily.
The upcoming FOMC announcement on the 18th is going to be one of the most impacting events in years. After five years of steadily falling risk in both equities and bonds, the tide is about to turn. From this month going forward, risk will be on the rise in both markets, and it will continue rising until rate normalization by 2017-18.
The first announcement of any plan is always the most potent. Even though monthly bond purchases will be phased out in steps by about mid-2014, the bulk of the added risk will be factored into both markets early, beginning this month.
Subsequent announcements of a second and third reduction will be less impacting, while the announcement of the final reduction, which terminates the bond buying program altogether, will likely have no impact at all.
September: In equities, therefore, we will most likely see a sharp sell-off this month and the next, as forward-looking investors scramble to factor in not just the first bond tapering but the entire termination of the program, with small and mid caps falling more than the large, and heavily indebted companies falling the most.
Bonds and Treasuries, on the other hand, are likely going to have a shorter correction, possibly stabilizing slightly above 3% on the 10-year note by the end of September.
October should see a slight rally in bonds as investors continue selling equities in their discovery of their true level of risk. When bond yields climb to levels not seen in over two years, investors will realize that 3% on the 10-year note is pretty good reward for the new level of risk, and yields should come down a little for the increased buying.
But come November-December, the all-important holiday shopping season will once again favor equities over bonds. According to the Stock Trader’s Almanac, since 1950, December has been the top gainer of all 12 months in percentage terms, and it will likely start us on another equity bull run that takes us into Q2 of 2014. The flight to equity will once again set bonds back, with the 10-year’s yield likely reaching higher than even Gundlach’s expectation of 3.1% by year end.
The long-term fixed income market is about to fade away. Stay in short-duration variable-rate bond funds and large cap equities for now. The era of rising risk is upon us, and the first blow is always the hardest.
If you liked this article, you may also enjoy: