Nothing Happens in June - The Truth About Bonds - Part 1

Nothing Happens in June - The Truth About Bonds - Part 1

[caption id="attachment_437" align="alignleft" width="150"]John G. Finley, CFA John G. Finley, CFA[/caption]

One of the songs on my iPod is titled “Nothing Happens in June.” I’m not sure what the song writer had in mind exactly when choosing that title, but he apparently wasn’t thinking about the Chicago Blackhawks or the world’s capital markets. It’s not very often that you see equities, bonds and commodities all selling off at the same time, but that’s what happened in the days following Fed Chairman Ben Bernanke’s press conference on June 19th. The 10-year Treasury bond yield increased from 2.19% on June 18th to 2.73% on June 25th.

I’ve carefully read through a printed transcript of his remarks and the Q&A afterwards, looking intently for something that investors didn’t already know.1 I saw nothing that caused my heart rate to accelerate, pupils to dilate and beads of perspiration to appear on my forehead. The Fed did reduce their estimated growth rate of U.S. GDP slightly, but I don’t think that had much of a “surprise” factor.

As most of us know by now, investors often over-react to negative or confusing news, thus driving markets too low as the “herd” mentality kicks in. In the face of uncertainty and the accompanying anxiety, we often allow fear of the unknown to have the better of us. The big unknown when it comes to the Federal Reserve right now is the prospect of the end of Quantitative Easing, the current Fed policy of buying $85 billion in Government bonds and mortgages every month to help keep interest rates low.

While market observers often disagree about the overall effectiveness of such policies, everyone agrees that interest rates will have to go up eventually. It’s not a matter of if, but a matter of when. And that is the crux of the problem. There have been so many predictions and discussions in the financial press in recent years about the imminent rise of interest rates, that many investors, upon hearing Chairman Bernanke mention the idea of ending QE, promptly sold their bond mutual funds to the tune of an estimated $60 billion dollars in the last four weeks.

Bernanke, however, went to great pains in his speech to explain that the eventual end of QE (often called “tapering” in the media) is not an end to the Fed’s current “highly accommodative” monetary policy, since he also said that the overnight Fed Funds rate would continue to stay near zero until at least 2015. He made it very clear that the Fed is not going to move suddenly from a policy of easing to tightening, especially since the current economic picture in the U.S. is not that robust and unemployment is much too high. He emphasized that monetary policy changes would only be considered in light of future economic data. Higher interest rates will raise borrowing costs for businesses and consumers, which can reduce the demand for goods and services. This is not what the Fed wants to have happen when unemployment remains stuck at 7.6% and many other workers are underemployed or have dropped out of the workforce altogether.

In Part 2, we'll look at how these responses stack up.

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