In our “Thoughts on the Current Outlook” dated April 9 of this year, we said:
We aren’t suggesting that you rush to sell all of your bonds immediately because we don’t expect this rise in rates to occur suddenly. But we are actively reducing the duration risk in client portfolios as we think this rise could happen as rates return to “normal” levels. This normalization of rates comes with some good news though: interest rates are likely to rise as the economy continues to recover and approaches its long term growth rate.
Higher growth will give rise to two conditions leading to higher rates. First, the Federal Reserve will likely back off of its program for purchasing bonds, which we believe has artificially suppressed bond yields. Second, better growth typically means a return of inflation as incomes rise, demand rises and prices respond.
Events of last week jumbled the order we had anticipated. Prior to last week, the Federal Reserve had only hinted at considering “tapering” their purchases of US Treasury bonds and mortgage bonds if the economy continued to improve. Last week, in conjunction with the Fed’s regular meeting, Federal Reserve Chairman Bernanke laid out a relatively specific plan for tapering their purchases later this year and stopping them next year, effectively anticipating that the economy will continue to improve, or at least that is how the markets’ interpreted his comments.
The markets’ reaction to this change in Fed intentions was violent. Interest rates spiked, bond prices tumbled and stocks followed suit. To give you a sense of the magnitude of the move in interest rates, the yield on the 10 year US Treasury bond was 1.64% on May 1, 2.16% at the end of May and it closed Friday at 2.51%. We had expected that this rate might move into the range of 2.75 to 3.00% over the next year. Instead, we got about three fourths of the move in just a few weeks.
Markets don’t like surprises, particularly from the Fed, so bond and stock prices dropped swiftly. And the downward moves in prices of closed end bond funds have been particularly stunning. However, there is a silver lining. This negative investor sentiment presents a great buying opportunity in our opinion. Over the last few days, we have been selling open end bond funds and buying closed end funds at prices we view as exceptionally attractive. We also expect to add to stocks as well, although those corrections have been more selective and we will be more cautious in our buys.
We will be publishing our new investment outlook in early July. It will have a much more complete discussion of the issues that the new Federal Reserve stance has created. These issues extend well beyond our shores as the impact of the world’s largest economy changing its monetary policy has large ripple effects.