The Bernanke Storm

June 26th, 2013

by Don Gould

One of the market’s periodic storms washed ashore in earnest last week, with both stocks and bonds tumbling together. Actually, bond prices began their downtrend around May 1, while stocks followed suit about three weeks later. Both stocks and bonds accelerated their decline last week after Fed Chairman Bernanke’s remarks about the central bank’s plans for potentially cutting back on its massive and unconventional bonds purchase program ($85 billion monthly), known as Quantitative Easing or QE.

What Did Bernanke Say, Exactly, That Set Off the Storm?

In essence, the Fed said:

1. The US economy is in better shape today than a few months ago.
2. If the improvement continues, the Fed could begin to wean the economy from its QE monetary stimulus before long.

Arguably, both parts of that statement are good news. The economy is doing better – certainly a positive. The Fed might start reducing QE soon – also a good development when one considers how QE and related policies have distorted asset prices, created risks of inflation and market instability, and heavily penalized the most conservative segment of the investing public – those depending on short-term fixed income instruments such as bank CDs and money market funds.

But understandably, investors viewed good news in the longer term as bad news in the short run. After all, any hint that the Fed might remove the punchbowl was bound to dampen spirits. Virtually all asset classes have fallen in concert over the past week.

Also contributing to the market jitters are reports of tightening credit markets and slower growth in China. Given China’s outsized influence on the world economy, any slowdown there will ripple through a host of global markets, including stocks, real estate, and commodities. Still, China’s absolute growth rate is the envy of most developed nations.

What This Means to You

Bond prices are falling, but the sky is not. It’s certainly the case that the price of existing bonds (i.e., the ones you already own) move inversely with interest rates. That said, the media has been nothing short of hysterical on this point, contributing to some panicked selling by retail investors. Consider that in the wake of the sharpest rate spike in more than a decade, a bond index mutual fund (replicating the performance of the entire US taxable bond market) is down about 3% in the past seven weeks. Not pleasant, but hardly a catastrophe. Moreover, almost no one initiated their entire bond portfolio on May 1, so it’s best not to measure performance only from that recent peak.

Also forgotten in the rush is the fact that bond returns have two components – price change and interest income. Even in a rising rate environment, bond investors recoup their price losses over time through reinvestment of interest income at new, higher interest rates. With interest rates on cash stuck near zero for the foreseeable future, bond investors could come out ahead despite rising interest rates.

As for the equity market, it’s worth noting that even after the recent pullback, US stocks are only back down to their late April levels. After a 4-year stretch of rising stock prices and more than 30 years of rising bond prices, it’s easy to forget that the path to our long-term goals is anything but a straight and predictable one-way street.

What to Do—and Not Do

Let’s start with what not to do. Don’t make big changes to your portfolio. Decisions driven by emotion are frequently bad ones. Portfolio strategies adopted in calmer times with a clearer head stand the best chance of achieving one’s long-term goals. That is not to say that either the stock or bond markets have found their bottom. No one can know that in advance. What we do know, from experience, is that greed and fear (today’s prevailing emotion) often lead to ill-timed investment moves. Even those who exit well before the bottom almost never get back in at the bottom. Instead, it’s frequently the case that investors don’t regain the confidence to re-establish their portfolios until prices match or even exceed the earlier sale price.

We do not discount the emotional toll whenever markets get volatile and asset values gyrate. We know it’s stressful, and take seriously our role as a steadying influence. It’s important to remember that we’ve been through these gyrations many times before and no doubt will experience many more in the future. Remind yourself, too, that your ability to keep your eyes focused on the long-term has generally been well rewarded over time. Smartphones and cable TV are wonderful in many ways, but their 24/7 font of breathless financial commentary may be hazardous to your wealth.

 

 

2 Responses

  1.  

    Does the increasing short term ( 1 to 3 yr) bond yield better compensate for the decline of bond value? Short term bond funds have to turn over more quickly than a 10 year note so the thinking is that you can readjust more quickly to the changing interest rate landscape. I don't know if this is a good question. I just wanted to be the first one to respond to the blog.


    • SupportDemo says:
       

      You’re correct that short-term bond funds more rapidly adjust to rising rates since their portfolios turn over more quickly and therefore get reinvested sooner at new, higher rates. This is reflected in the relatively small decline in the price of short-term bond funds in response to the general rise in interest rates. However, given the steepness of the yield curve at present (i.e., the fact that longer term rates are substantially higher than short-term rates), there is a significant give-up in yield in exchange for the reduced interest rate risk of short-term bond funds. In other words, the risk-reward tradeoff is meaningful right now. – Don Gould

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