- How will tapering of Fed monetary policy impact interest rates, credit spreads, and stocks?
- Will investors rotate from bonds to stocks?
- Who will be the next Fed chairman?
One of the key themes that I’ve been focused on in recent months has been the possibility of investors selling some of the large bond holdings that they’ve steadily acquired since the Fed (Federal Reserve) started its zero interest rate policy (ZIRP) in 2008 and its quantitative easing program (QE) in 2009. The big unknown is what such a rotation may mean for interest rates, credit spreads, and even the stock market.
Since the 2008 financial crisis, the Fed has brought short-term interest rates down to zero (through ZIRP) and added trillions to its balance sheet (through QE) in an effort to stimulate the U.S. economy. One purpose of this was to coax investors in search of higher yields into riskier investments in order to bring interest rates down and asset prices up. Since late 2007, investors have put more than $700 billion into bond funds of all types, according to fund flow data from EPFR Global. This reach for higher yields eventually found its way into the more yield-oriented sectors of the stock market such as REITs and utilities, which in turn boosted equity prices in general.
The Fed’s QE program has largely worked in helping to increase asset prices, as the recent all-time highs in the major stock market averages show. This has created a positive wealth effect across all financial assets, which was one of the stated goals of the Fed.
Taper time: The reaction so far
It’s now clear that the Fed would like to start reducing its bond buying program, and eventually maybe even get out of the QE business altogether. The question is whether it can do so without disturbing the price equilibrium of financial assets.
We got a taste of this in May and June, when the topic first came up. At that time, the S&P 500 Index corrected by 6%, the yield on the 10-year Treasury rose from 1.6% to 2.7%, and high-yield credit spreads widened by 120 basis points—all in the span of a few weeks. Furthermore, volatility for stocks and bonds returned, and the Fed backed off its hawkish stance. That about-face allowed things to quiet down in July, and quickly enough the stock market rallied to a new all-time high.
In recent days, however, stocks have started falling again, with the yield on the 10-year Treasury rising to 2.8% for the first time since 2011, and the S&P 500 Index correcting from its recent high of 1,710, to 1,663 as of August 15. And, in recent weeks, investors have been rotating out of bonds and into equities, according to fund flow data from EPFR Global. This makes me wonder whether a long-awaited rotation has begun. On top of this, there’s also some uncertainty regarding Fed Chairman Bernanke’s successor. The front-runners appear to be Janet Yellen of the Fed, and former White House official Larry Summers. While the former would likely be seen as a smooth transition from Bernanke, the latter might be viewed as more of an unknown, which might cause some market volatility this fall when the announcement is made by the president.
If the stock market can hang in there even as Treasury yields rise further, then that would be a good sign for it in terms of its resiliency in the face of rising rates and reduced monetary support. It would also lend support to the notion that stocks may have finally embarked on a new secular bull market, driven by a continued rotation into stocks.
But we have to be prepared for the possibility that the stock market could suffer some indigestion in the weeks ahead in the form of rising volatility, as investors anticipate the September Fed meeting and possibly an announcement of when the Fed will start to taper. We should also find out around that time who will become the next Fed chairman.
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