Business
The Sterling ReportEugene StanleySunday, June 30, 2013Asset prices around the globe, particularly stocks, bonds and commodities dropped significantly over the last couple of weeks due to increased market anxiety that Central Bank accommodation around the world is coming to an end. Were markets over-reacting or being too previous in their actions and what are the implications for investors? Are their portfolios at significant risk of loss or are there opportunities aplenty to capitalize on? This article will briefly contextualize recent market behaviour and explore the resulting opportunities and or challenges facing investors, primarily bond investors.Bonds, like stocks, have experienced significant gains in valuation since their demise during the financial and credit crises of 2007-2008. Much of the recovery however has been the result of Central Bank interventions around the world wherein interest rates have been reduced to historic low levels and vast amounts of liquidity injected in the financial markets through bond purchases. In the United States, for instance, the US Federal Reserve Bank (Fed) cut and maintained signal rates to near zero percent and has been providing liquidity support through bond purchases of $85 billion per month since December 2012 to boost economic activity and improve labour and housing market conditions.Economic activity has been improving in the US, unemployment has fallen from the recession high of 10% in 2009 to 7.5% and the housing sector continues to rebound. Based on announcements in January 2013, the Fed intended to keep signal rate at zero until mid 2015, and maintained monthly bond purchases at $85 billion until either unemployment fell to 6.5% or inflation rose above 2.5%. However in a more recent update on June 19th the Fed has revised its unemployment target to 7% and suggests that monthly purchases may begin to shrink as early as this year if the US economy appears to be meeting its growth and employment projections.Markets have been roiled from the Fed’s latest announcement as investors, strategies and analysts have been speculating that the Fed may begin ‘to taper” its bond purchases as early as September 2013 and by as much as $20 billion per month concluding early 2014 as the US economy continues to show signs of recovery. They also suggest that the Fed may start to increase rates by as early as mid 2014.Bond prices (from Treasuries to corporate bonds, investment grade to non-investment grade bonds) have dropped as a result of the current market speculation on imminent Fed policy sending yields higher with longer dated riskier bonds suffering the brunt of the impact. 10-year US Treasuries which were trading at a price of 99, or a yield of 2.1%, on June 6 dropped 7 points to 92, or a yield of 2.61% as at June 25. Riskier bonds however have seen price corrections by as much as 20 points.Some analysts are suggesting that current market events represent the end of the “price bubble” as interest rates are poised for increase henceforth, while others say the markets not only overacted but misinterpreted the Fed’s latest message as the economy is not sufficiently healthy for the Fed to pull back on stimulus. Right or wrong however, there are investment risks and opportunities facing existing and potential investors because what is for certain is that at some point the Fed will withdraw its monthly stimulus and interest rates will begin to rise. Whether this happens this year or the next will depend on the economic fortunes or woes of the US economy and markets will trade accordingly. Good economic results will support the case for the Fed to cut stimulus and bond prices will expectedly fall further, while poor economic data may result in the Fed delaying a pull- back on stimulus thereby providing support to bond prices.Investors who believe that markets overacted or got it wrong (as economic data on June 26th suggests with the 1st quarter GDP being revised from 2.4% to 1.8%) have the opportunity to acquire bonds at relatively cheaper prices (higher yields) and increase the prospects for capital gains when yields retreat (prices appreciate) in line with their expectations; but risk further capital losses in the event rates move against them and go higher. For the retail investor however capital losses are only realized if the bonds are sold and investors who are comfortable with the cash flows or yield to maturity on their current bonds need not rush to sell.Investors who believe that interest rates are on the rise may opt to take profits on their existing portfolio or sell to reduce further losses. They may either re-invest or acquire shorter dated securities or variable rate securities to reduce future price risks emanating from rising interests.Eugene Stanley is Vice President, Fixed Income and Foreign Exchange Services at Sterling Asset Management Ltd. Sterling is a licensed dealer and provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at http://www.sterling.com.jm/
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Fed tapering: Fear or opportunity
