Since early last summer, the U.S. Federal Reserve has been talking about tapering. To support the economy during the pandemic recession, America’s central bank has been keeping longer term interest rates artificially low by purchasing U.S. Treasury bonds and mortgage-backed securities to the tune of $120 billion per month, a process known as quantitative easing, or “QE” for short. Reducing the monthly amount of those purchases, or “tapering” is now expected to begin before the end of this year.
The second half of September saw heightened risk market volatility in reaction to prospects of slower economic growth, troubles in China and the likelihood of Fed tapering. Investors need now consider the implications of an imminent monetary policy shift and how securities prices may be further impacted in the months ahead.
While QE and other aggressive central bank policies were deemed necessary in 2020 to contain last year’s COVID fallout, the economy has since picked up steam and a reversal of those policies is now warranted. Besides attempting to boost overall employment, the Fed must also consider the rising tide of inflation. Higher interest rates have traditionally been used as a tool to keep consumer prices in check.
In late September, we caught a glimpse of what may lie ahead when the S&P 500 index plunged almost 2% on 20 Sept., one of its largest declines this year. Although, the drop was largely attributed to the financial crisis surrounding the China Evergrande Group, the Fed tapering narrative did not help. Longer term bond prices were also slammed that week as interest rates climbed to recent new highs. Last month, the 10-year Treasury yield rose by about 21 basis points from 1.28% to 1.49% and have since pushed to 1.55% as of this writing.
Rising long-term bond yields also contributed to sloppy equity markets in September. The MSCI World stock index declined by 4.29% and the S&P 500 fell by 4.76% during the period. Notably, the Russell 1000 value index outperformed the Russell 1000 growth index by 201 basis points for the month as investors rotated from growth to value stocks. Growth stocks in sectors such as technology and healthcare are inherently more sensitive to interest rates.
Under the theory that stock prices represent the discounted net present value of future cash flows, growth stocks become mathematically less valuable in a rising rate environment where their intrinsic value is more heavily weighted towards expected earnings streams farther out.
Easy money is generally good for both stocks and bonds, but when the Fed begins to withdraw stimulus from the system, securities prices can suffer. The term “taper tantrum” refers to the 2013 reactionary panic which triggered a spike in U.S. Treasury yields and a decline in the stock market after investors learned that the Fed was slowly putting the brakes on its QE programme.
The 2013 tantrum began under former Fed Chief, Ben Bernanke when he tipped the committee’s intentions during an appearance before Congress in May of that year. From May through late August of 2013, longer term interest rates rose over 100 basis points while the stock market plunged about five percent before resuming its upward trajectory later in the year.
Expect greater market volatility during the months ahead. Readers of this column know we keep an eye on the CBOE Volatility Index (VIX). Market drawdowns such as we saw late last month are typically accompanied by spikes in the VIX. After averaging just over 20 during the past 12 months, the volatility index jumped to 25 on the day of the market’s recent sell off. More frequent spikes and higher average volatility measures should be anticipated as the Fed begins withdrawing liquidity from the system rather than just talking about it.
Perhaps the greatest difference between 2013 and now is how much less room the Fed has to manoeuvre. Thanks to its unconstrained spending initiatives and lack of fiscal accountability, U.S. government debt has ballooned to around $28.43 trillion, almost doubling since 2013 when it was estimated at $16.7 trillion.
Given these burdensome debt levels, each uptick in interest rates increases America’s debt servicing costs exponentially and places further pressure on future spending plans. With so much debt outstanding, the Fed can only afford to raise interest rates by a much smaller amount this time around.
Another near-term constraint on monetary policy is political. Fed chair Jerome Powell is up for reappointment next February. To retain his position, he is unlikely to make any dramatic moves which could jeopardise his standing. The Powell Fed is more likely to make more nuanced and well broadcasted moves which will not roil the markets.
For these reasons, we might consider this a period of “taper testing”, rather than a full blown “taper tantrum” as we saw in 2013. The testing component comes about as we are truly in uncharted territory with respect to government debt levels. The FOMC will reserve the right to interrupt its tapering initiatives if financial markets begin to behave badly.
While tapering will likely commence this year, an increase in the federal funds rate will be further off. Following the September FOMC meeting, the committee’s so-called dot plot, which the central bank uses to signal its outlook for the path of interest rates, shows officials are now evenly split on whether it will be appropriate to begin raising the fed funds rate next year. The median projection in its latest plot indicated no rate increases until 2023.
With short term interest rates pinned near zero, conservative investors, parked in money market funds or bank deposits, will have to wait longer for good news. In this environment, it may be tempting to take more risk by moving out the interest rate curve to obtain higher yields.
In fixed income, we currently favour higher coupon issues trading to short-term call dates. Equity investors should strike a balance between growth and value.
Bryan Dooley, CFA is Head of Portfolio Management at LOM Asset Management Ltd in Bermuda.
Please contact LOM at +1 345 233-0100 for further information.
This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.
Related Videos
