Prepare for Stimulus Tapering in September

Traders have been seeing the dark clouds on the horizon and have known for a while now that the Federal Reserve is preparing to begin reducing its monthly bond purchases later this year.

But with Friday’s jobs report, the economic winds pushing stimulus tapering have picked up speed. The storm is now expected to make landfall much sooner than previously thought.

Bond traders are already fleeing, pushing up the 10-Year Treasury yield to 2.75%, its highest in 23 months. While equity traders held their ground, with the S&P 500 actually rising on Friday by over 1%, many feel equities will get their share of ravaging soon enough as stimulus reduction deflates them as well.

To where in the investment landscape can we run? Let’s first survey the area by looking at last week’s report and what it tells us about the economy and the Fed’s most likely response.

Jobs Data – the Good, the Bad, and the Ugly

Federal Reserve Chairman Bernanke has repeatedly stated that any moves in stimulus reduction would be data dependent, especially in regards to the unemployment and inflation rates. Good numbers would increase the likelihood of tapering sooner, while poor numbers would likely delay it a few months more.

Yet Friday’s jobs report is not really as definitive as many would have desired. It was truly a mixed bag.

• Good: 195,000 new jobs were created in June while analysts expected 165,000. May’s jobs number was adjusted upward to 195,000 from the previous 175,000, while April’s number was similarly adjusted higher to 199,000 from its previous 149,000. New non-farm jobs now average +182,000 per month over the past 12.
• Bad: The unemployment rate remained unchanged at 7.6%. Unemployed persons also remained unchanged at 11.8 million. “Both measures have shown little change since February,” the report declares.
• Ugly: The civilian labor force participation rate of 63.5% in June was up 0.1% from May’s 63.4%. But it is down 0.3% from 63.8% twelve months ago.
• Good: The number of new part-time jobs increased by 322,000 in June.
• Bad: These workers were “part time because their hours had been cut back or because they were unable to find a full-time job,” the report explains.
• Ugly: 2.6 million persons were marginally attached to the labour force. “They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey,” the report notes. [If they had looked for work in the prior month, there would be a total of 14.4 million unemployed, raising the unemployment rate to 9.27%.]
• Good/Bad/Ugly: While professional and business services jobs rose by 53,000 in June, leisure and hospitality added 75,000 jobs. Though these were good increases, the bulk is in the lower-paying, less stable L&H sectors. Meanwhile, federal government employment continued to fall, losing 5,000 jobs in June for a total loss of 65,000 over the past 12 months, a direct consequence of the sequester.

As one last point of concern, employment in other major industries including mining, logging, construction, manufacturing, transportation, and warehousing showed little change in June. This indicates no or slow economic expansion, meaning that the bulk of June’s new jobs were merely filling holes and did not come from real economic growth.

Market Reactions

At first, the markets didn’t really know what to make of Friday’s numbers, as both the equity and bond markets remained uneventful until about noon. When traders determined the report was net positive, the bond market sold off, with the 10-Year Treasury yield surging 20 basis points to end the day near 2.75%, the highest in 23 months.

Bond traders are seeing this as a green light for stimulus tapering – and sooner too, as a Reuters poll of the largest institutional bond dealers found. “A good guess would be in September,” Ray Stone, an economist at Stone & McCarthy Research Associates, predicted to Reuters. “I don’t think they are anxious to pull the trigger beforehand.”

Stocks, on the other hand, remained bullish, with the S&P 500 gaining 1.02% on Friday. Although reduction in stimulus can be detrimental to stocks, the optimism in equities could be on the expectation that “the U.S. recovery appeared to have enough momentum to weather the rise in interest rates,” Reuters concludes. After all, the Fed wouldn’t be entertaining the idea of stimulus reduction if the economy were not strong enough to stand with less stimulus support.

But some are not so sure. Bob Brusca, chief economist at FAO Economics, expressed to Yahoo’s The Daily Ticker that “it’s a good report but ‘like all of these reports it’s got some good, bad and ugly parts.’” Brusca notes one ugliness is how June’s new jobs plus April’s and May’s upward revisions had absolutely zero impact on the unemployment rate. He figures all this new job creation is just barely keeping pace with population growth.

Even so, Brusca also believes the Fed will begin tapering in September, it having been pretty much decided last month. “The Fed is sort of on automatic pilot to taper unless something happens,” he assesses. In his view, only some truly fundamental weakness will change its plans now.

Perhaps the most logical expectation from reduced stimulus is a correction to both bond and equity markets. Both markets were boosted by stimulus, so both markets should suffer some withdrawal symptoms. Equities may give back some of their gains soon, especially as we have yet to see that customary mid-year pull-back.

Yet given the generally improving economy – slow though it may be – any correction in equities should be short lived, and to a lesser degree than the landslide currently washing away bonds.

How Should Investors React?

Knowing that the approaching stimulus reduction storm is going to change the investment landscape, investors need to anticipate where the next green pastures will spring up and migrate there.

We are about to enter a period of slowing Fed bond purchases for about the next 12 months, followed by gradual interest rate rises for the next 3 or 4 years after that – barring any stalls along the way.

Over the past two months, the markets have already been showing us how the investment landscape will change:

• Ugly: Bond traders are migrating out of long durations into shorter ones. While the iShares 1-3 Year Credit Bond ETF (NYSE: CSJ) is -1% over the past two months, the iShares 10+ Year Credit Bond ETF (NYSE: CLY) is a dreadful -11.7%. The reason shorter duration bonds are faring better is because they will be maturing sooner and will be replaced by bonds bearing a higher interest rate, thereby generating higher income sooner than longer duration bonds.
• Bad: Also tumbling, though to a slightly lesser degree, are variable rate bond funds, such as Eaton Vance Senior Floating-Rate Fund (NYSE: EFR), at -8.3% over two months, and Nuveen Floating Rate Income Opportunity Fund (NYSE: JRO), at -8.4%. While these funds hold business loans with an adjustable interest rate, most rates will not adjust until 12 months after borrowing rates actually change. Thus, they will still take a hit during general bond market sell-offs. But once the bond landslide stops, shorter floating rate bond funds should recover more quickly than funds with longer fixed rates.
• Good: The best performance among lenders is found among the business development corporations (BDCs) and regional banks, including: Prospect Capital Corp. (NASDAQ: PSEC) changing -1.1% over two months, with a current yield of 12.3%; New York Community Bancorp Inc. (NYSE: NYCB) up at +6.4% over the same period and yielding 6.42%; and KeyCorp (NYSE: KEY) up a stellar +16% over the same two months.

Wells Fargo analyst Matthew Burnell explained that by being smaller, regional lenders face “less onerous risk weightings for residential mortgages under the Basel Committee on Banking Supervision,” Bloomberg paraphrased.

Furthermore, it is strongly expected that the demand for business loans will continue to grow as the economy recovers. In turn, profits from those loans will increase as interest rates gradually increase. Lending companies stand a good chance to outperform the broader market all the way to rate normalization in 2018, give or take a year. And most carry dividend yields surpassing 6%.

As the stimulus season changes, we know to where the greener pastures are shifting. The question now is: when do we migrate there? Do we wait for the actual Fed announcement in 3 or 6 months? Or will it be too late by then?

At this point, it’s a lot like deciding when to pack up and take shelter from an approaching storm. We don’t need to get soaking wet to understand the need to move.

And don’t be fooled by any temporary breaks in the clouds. Any bond rally dropping yields back to the low 2% on the 10-year is a blue patch of sky that will be quickly engulfed. Once tapering begins, the sun will likely not shine on long term bonds for many years to come.

Joseph Cafariello

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