Session 23—“Fed Minutes Show Sharp Division Over ‘QE’ Duration”

Remember the “Fed Bolt From Hell” from sessions 15 and 18?  Well, the headline above would make one think that “FBFH” might be a lot closer than we think.  I mean this is pretty dire stuff as it gives the impression that maybe a real movement toward a policy shift was at hand (or at least heated controversy pushing that move).  The headline emanated from the Wall Street Journal’s Market Watch site Wednesday morning, April 10.

Not to worry, when you clicked on the headline and went to the (very short) full story, the word “sharp” is replaced by “clear” (a bit less inflammatory).  A link to the full story is attached and you will see what appears to be a fairly levelheaded discussion emerging.

For the purpose of this blog when the Fed does, or is amenable to take its foot of the gas (i.e. ‘QE’), you may get the first major catalyst we have had for a real correction.  I say “may”, because there appears still to be so much money on the sidelines. Also, because the market will be so well prepped by the media hype ahead of the fact, the effect of the actual event may be muted. Even a significant, quick run-up in rates (if the Fed could stomach this) might only stymie the market for a short time. Again, the reason for this is that a tremendous amount of money came out of the market in the last few years. It is currently siloed in bonds and bond funds, much of it  not earning a real rate of return.

To give you a flavor of the potential market fuel still unmoved and on the sidelines, we give you this article entitled “In Search of the ‘Great Rotation’.”  ‘The Great Rotation” is the term being used on the street to describe the rotation out of bonds into other equity assets (who knows, possibly stocks). This could be significant, as trillions of dollars have gone into fixed income since the 2008 meltdown.  According to the author, Mark Hulbert, even with the market reaching new highs that rotation hasn’t even begun yet.

Hulbert is a credible source with excellent credentials as a contrarian, usually a good mind when it comes to debunking common market misconceptions.  As I said earlier, Hulbert does not see this rotation as even starting yet, while many pundits credit the “rotation”, in part, for the markets recent strength.

To try to tie this somewhat rambling post together, when the Fed abandons “QE”, stocks will go down and so will bonds.  However, bonds may not necessarily recover, even if stocks do. The higher interest rates that may come with the removal of ‘QE’ may just be a sign of a much stronger economy and confidence on the part of the Fed that the stimulus was no longer needed; ergo, good for stocks, not so good for bonds.

The following illustration may be elementary to some of my readers, but for many who have never experienced a down bond market or know the mechanics, this lesson in fixed income 101 might provide some illumination.

Let us examine what would happen to the market price of a ten-year, 2% U.S. Treasury, which would cost today about 101.5 ($1015.00 per  $1000 face value) if rates move up.  The reason that you have to pay more than par for these bonds is because the market is currently paying up for ten-year treasuries.  Today the market yield on the ten-year is only 1.79%, which would indicate significant fear and skepticism in light of the record highs that the stock market continues to post.  This is healthy as it represents that ‘wall of worry’ bull markets have to climb.

OK, back to our ten-year treasury illustration. If interest rates go up 1% over the next year, the value of that ten year you paid 101.5 for will become worth about 9% less, or 92.5 (i.e. your investment of $1015 will become worth $925 = a paper loss of $90/ bond). That paper loss would equal 4.5 years worth of income at $20 per year/$1000 face (the 2% coupon).  Now, you don’t have to sell.  Eventually you are guaranteed to get your principal back* and your coupon.  That guarantee is the beauty of owning governments.  In the meantime, however, if you have inflation and pay taxes on the income from those bonds, you are not likely to have a real (inflation-adjusted) return on your investment, and the dollars you get back at maturity will have significantly lower purchasing power.  Also, you will have to consider the opportunity waived by not being in other “riskier” investments or opportunity to buy higher yielding bonds as rates move up.  But wait a minute, this example shows that even U.S. government bonds might have risk!

Despite the naysayers, I believe the U.S. is growing and will continue to grow (even in the absence of ‘QE’), and that our expansive monetary and fiscal policies will eventually be inflationary, which leads me to the position that investors need to be owners and not lenders.  We deal with what might happen to stocks in a rising rate environment in sessions 15 and 18 (“Fed Bolts….”).  “Fed Bolt…part II” has a real world example from 1994 where the outcome of a Fed generated upward interest rate move ended up very favorably for stocks.

Back to the media and our headline,

—“Fed Minutes Show Sharp Division Over ‘QE’ Duration. ” This is just a sampling of the hype that will precede and follow actual removal of ‘QE’.  Be not afraid. Be prepared for it and sleep better.

Let me know what you think.

*BTW you will not get back the $15 dollar premium/ $1000 face value that you paid to receive the 2% coupon when actual market rates were 1.79%.

The information presented in kortsessions.com represents my own opinions and does not contain recommendations for any particular investment or securities.  I may,  from time to time, mention certain securities for illustrative purpose, names where I personally hold positions.  These are not meant to be construed as recommendations to BUY or SELL.  All investments and strategies should be undertaken only after careful consideration of suitability based on the risks, tolerance for risk and personal financial situation.