Interest Rate Risk: The Fed and the Market

Posted on May 9, 2014 by

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Over the last 18 months we’ve seen that when the Fed hints at a change in Quantitative Easing or interest rates, the markets get jittery. We take a look at how a Fed-induced market correction might unfold.

keywords: asset allocation, diversified portfolio, stocks bonds

Related post: Bond/Stock Correlation: A quantitative headwind for allocation strategies

As of this writing (May 2014) we’re at the crest of all time market highs. Some investors are beginning to believe that we may be due for a correction. There are a number of scenarios regarding how that correction might unfold. A lot of them relate to the potential that we’re on a price bubble that may burst soon. (These two articles seem to downplay that risk: Warning signs of a bubble, Bubble? Venture capitalists don’t think so.)  Other scenarios involve interest rate rates and the Fed. In this article we’ll take a look at that risk.

The Fed’s policies have connected stocks and bonds in an unusual manner

The Fed’s policies since 2009 (low interest rates and Quantitative Easing — bond buying) have served to drive investment to stocks in two ways:

  1. Low bond interest rates force investors to look to stocks and risky fixed income assets for reasonable return.
  2. Low interest rates enable investors to borrow money to buy more stocks and risky bonds than they might buy otherwise.

This combination of factors has contributed significantly to the bull market since 2009.

How the interest rate correction scenario might unfold…

If and when interest rates rise the relationships above may trigger a steep decline across stock and bond assets as follows:

  1. Higher interest rates on new bonds will trigger price drops on existing bonds.
  2. New bonds will become more attractive, spurring rotation out of stocks.
  3. As borrowing costs rise, investors will have to unwind (sell) their positions in stocks and risky fixed income positions.

Those 3 factors taken together could result in a simultaneous drop in bond and stock prices. We saw in May and June 2013 that the mere suggestion that the Fed might tighten money policy triggers this process. From an AP article:

Last month (June) stocks plunged after Bernanke said the Fed could slow the bond purchases later this year and end them next year if the economy strengthens. Since them, Bernanke and other Fed members have stressed that any change in policy depends on improvement in the job market and economy, not a target date. That has helped push stocks to new highs.

We’ve been testing these waters since May 2013: No correction so far…

As mentioned above we saw this scenario in action starting in May 2013. I wrote about it at the time in another article. At that time, to be honest, I expected a significant correction to unfold before the end of 2013.

But since May we’ve seen the Fed announce that Quantitative Easing would halt, and they’ve begun shutting it down (the taper).  Not only have these two events not caused a correction, the market has seen new highs.

The remaining risk on the table is interest rates, but Fed Chairman Janet Yellen has put that risk to bed for a while:

“We anticipate that even after employment and inflation are near mandate-consistent levels, economic and financial conditions may, for some time, warrant keeping the target federal funds rate below levels that the Committee views as normal in the longer run,”

Summary and outlook

The market seems to have been inoculated against interest rate risk after the initial response to hints of change in May/June 2013. Since that time, we’ve seen concrete action by the Fed to tighten their policies and the market has responded positively rather than negatively.

Even if the market were poised for a correction as a response to the Fed raising rates, that change does not seem to be on the near horizon.

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