David Joy - should investors have been spooked by last week's Fed announcement

Last Wednesday’s meeting of the Federal Reserve’s Open Market Committee (FOMC) was viewed as an opportunity for the Fed to clarify the confusion created by its chairman in remarks made to Congress back on May 22. At the time, in response to a question, Chairman Bernanke said that although the committee had not yet done so, it could decide to begin the process of tapering its QE3 bond buying program sometime during the next few meetings, depending upon the strength of the economic data. This caused some observers to bring forward their expectations of when a policy change might actually begin, while others remained unmoved. After those May 22 remarks, the range of expectations of when a tapering might begin extended from as early as September to as late as the first quarter of next year. And while the statement was somewhat ambiguous, it did serve to put investors on notice that the Fed would eventually initiate a move toward policy normalization, and do so in the not-too-distant future, assuming the economy was strong enough to handle it. That was enough of a warning to some investors to begin preparing. The S&P 500 peaked on May 21, the day before Bernanke’s testimony, and drifted fractionally lower, by just 1%, through the evening before the Fed’s meeting concluded on Wednesday of last week. Dividend paying bond proxies fell more sharply. Even still, stocks rallied in the several days leading up to last week’s meeting, in anticipation of a more sanguine assessment by the Fed. An adjustment process was underway in bonds as well, as interest rates continued to move higher, pushing bond prices lower. On May 21, the yield on the ten-year Treasury note was 1.93%. It closed last Tuesday at 2.19%.

Obviously, not everyone heard the Fed’s message from May 22 clearly enough. In an effort to be more explicit regarding the Fed’s intentions, during his press conference following the conclusion of the FOMC meeting on Wednesday, Bernanke said that tapering could begin later this year and be concluded by the middle of next, again depending on the data. Although, directionally this was not any different from what was said on May 22, it did put a more definitive timeline in place. The reaction was swift and severe. By the end of the day, the 10-year note yield had risen to 2.35%, and the S&P 500 had fallen 1.4%. More weakness followed on Thursday before stocks stabilized on Friday. Bonds kept on falling through to the end of the week. It didn’t seem to matter that, as the chairman stressed, the Fed would remain quite accommodative even after any tapering had begun, that the stock of assets on its balance sheet would remain out of the market, or that tapering did not mean no stimulus, just less of it, or that interest rates would likely remain unchanged for another couple of years. All that seemed to matter, at least for one class of investors, was the message that QE3 would eventually be phased out and that it was time to sell first and ask questions later. For these investors, questions regarding the strength of the economy, the outlook for corporate earnings growth and so on were of little importance. They were reacting to the prospect that central bank liquidity was peaking, and that was sufficient to trigger a wave of profit taking.

In light of last week and the start of this week, here is a look at the aftermath.

Bonds:
The bond market sold off heavily following Bernanke’s remarks. The yield on the 10-year Treasury note rose 16 basis points on Wednesday, followed by another 7 on Thursday and 11 on Friday. In all, the yield rose from 2.19 on Tuesday to 2.53% on Friday. In the process, its price fell 3.1%. Further insulated from the Fed’s QE buying, the yield on the 30-year bond rose far less, just 22 basis points between Tuesday and Friday, while its price dropped 4.55%. High yield corporate bonds saw their yield rise sharply, although the worst of the damage occurred over just the last two days of the week. The yield on the Bank of America Merrill Lynch High Yield Master II index rose to 6.99% on Friday from 6.59% on Wednesday.

The municipal bond market saw yields rise as well. According to the Bond Buyer, the yield on the 10-year Municipal Market Data index ended the week higher by 40 basis points at 2.63%. The yield on the 30-year index rose 46 basis points to 3.96%. Adding to the downside pressure in municipal bonds was a reported $2.2B in redemptions from municipal bond funds. Liquidity in the sector was hard to come by, as the selling pressure overwhelmed any buying interest. A number of new issues were postponed due the market conditions, but the volume of new bonds expected to come into the market this week is heavy. This will provide a good test of how much renewed buying interest there might be after the spike in yields. The Barclays Municipal Bond index has lost 3.2% this month. Bonds at the longer-end of the yield curve have fallen more than 5.0%.

Bonds of emerging market issuers suffered among the worst declines. The price of the Bloomberg U.S. Dollar Emerging Market Composite Bond index has fallen over 5% this month. Last week alone it fell 3.8%. But weakness in emerging market currencies has exacerbated the declines, as capital flows to emerging markets have reversed recently in response to economic weakness and expectations about the Fed. In the past month, emerging market currencies as a whole have fallen more than 5%. As examples, dating back to the second week in May, the Brazilian real has fallen 11% versus the dollar, and the Indian rupee has lost 9%. Both fell more than 3% last week alone.

Stocks:
Stocks fared no better. Between the close last Tuesday and end of the day on Thursday, the S&P 500 lost 3.8%. In the process, the index closed below its 50 and 65 day moving averages for the first time since December. For the week, U.S. stocks lost 2.1%. And the damage was mostly indiscriminate. Of the 98 domestic total market industry groups tracked by Dow Jones, only three managed to post a positive return for the week; life insurers, electronic office equipment manufacturers, and internet companies. At the opposite end of the spectrum were precious metals miners which experienced double digit declines. As were their fixed-income counterparts, emerging market equities were pummeled, losing 4.0% on Thursday alone in dollar terms, as measured by the MSCI Emerging Market Index. The index lost 5.6% for the week and has fallen an astounding 15% since May 9. The MSCI EAFE index lost 4.6% in dollar terms on Thursday, and 3.8% for the week, hurt in part by political instability in Greece, which only made matters worse.

Commodities:
The story was the same in commodities. On Thursday and Friday the Dow Jones-UBS Commodities index fell 3.6%. Gold fell $66 an ounce, or 4.9% on Thursday. For the week it lost $95 an ounce, or 6.8%. Crude oil fell $4.79 a barrel on Thursday and Friday, to close at $93.69, down 4.9% from Wednesday’s close. Copper lost 3.8% on the week.

Some of the weakness in commodities was attributable to strength in the dollar, as the DXY Index rose 2.1% over the final three days of the week. Some of it was undoubtedly in response to further evidence of economic weakness in China, where a sharper than expected decline in its June flash manufacturing sector purchasing managers survey was reported, as well as the emergence of a liquidity crunch in the bank funding market.

What Now?
Despite the fact that the process of adjustment to anticipated changes in Fed policy had been underway for several weeks, the violent response to Bernanke’s comments last week made it clear that further adjustment was necessary. And it came in a hurry. According to the Wall Street Journal, last week’s selloff in treasuries was the sharpest in a decade. The question now is whether there is more to come?

First, there are a few things to keep in mind. Even after the Fed begins to scale back its QE program, which it will only do if the economy is strong enough, by any standard it will remain exceedingly accommodative, and therefore supportive of economic growth and financial assets. In addition, interest rate policy is separate from QE. And the Fed does not anticipate a change in interest rate policy for two years. Furthermore, it is a healthy development in the evolution of the recovery from the financial crisis that the Fed is considering beginning to normalize monetary policy. This means we are making progress, something we should all welcome.
After last week’s losses, the S&P 500 is off its high by just 4.6%, and remains higher on the year by 11.7%. It is trading at a reasonable 14.5x this year’s expected earnings. So far, the uptrend remains intact. But if this extraordinary period of excessive liquidity provision is, indeed, coming to an end, it seems reasonable to expect some additional adjustment as positions are reconsidered. It seems unlikely that all of that activity has run its course. That does not mean that the bull market is over. What it likely does mean is that economic fundamentals will become increasingly important, and Fed liquidity will become increasingly less so.

At 2.53%, the yield on the 10-year Treasury note is at its highest in two years, and well off its low of 1.39% of one year ago. For those who bought then, the price decline has been painful. But, except for most of the past two years and a few brief episodes earlier in the crisis, treasury yields remain lower than any time in the last fifty years. That suggests that the return to normal market conditions over time will likely result in yields moving higher. It is unlikely that this readjustment has fully run its course as well. Working in bonds favor is the fact that inflation remains low. Longer-term inflation expectations have even fallen recently. But when and as the Fed recedes from the bond market, a powerful source of buying demand will no longer be exerting downward pressure on rates. And if the economy picks up a little, then presumably the demand for credit will exert further upward influence on bond yields. This latter point would be a welcome development, and would be supportive of stocks. But it remains appropriate to maintain a defensive posture in fixed-income, with reduced interest rate sensitivity.

The normalization of interest rates has a number of implications. As the private sector has deleveraged over the past five years, the public sector balance sheet has expanded. Low interest rates have largely made that expansion in debt burden manageable. As rates rise, budgetary pressures to service that debt will mount. This is true not only in the U.S., but elsewhere, most notably Japan. Clearly, more work needs to be done to restore fiscal stability in these economies. Reducing debt burdens and avoiding the harmful implications of rising interest rates will help. The same is undoubtedly true in the private sector. Low interest rates have no doubt resulted in some degree of leveraged speculation that will either be unwound in an orderly fashion as rates rise, or in some cases, end badly. By the same token, a return to normal interest rates over time will be a welcome development for savers who have been starved of income for the past five years.

Disclosure
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The Bank of America Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.

The Bond Buyer Municipal Bond Index represents an average of the prices, adjusted to a 6.00% yield basis of 40 recently issued municipal securities, based on quotations obtained from six municipal securities broker’s brokers. The 40 component issues are selected according to defined criteria and are replaced by newer issues on a periodic basis. This index is published daily and serves as the basis for futures contracts.

Barclays Capital 10-Year Municipal Bond Index: Is an unmanaged index with maturities between nine and twelve years. The Barclays Capital 10-Year Municipal Bond Index is the 10-Year total return subset of the Barclays Capital Municipal Bond Index.

The Bloomberg US Dollar Emerging Market Composite Bond Index measures USD fixed-rate securities issued in emerging markets as identified by Bloomberg. Included in the Index are Bloomberg’s USD Emerging Sovereign Bond Index; USD Emerging Market Corporate Bond Index; USD Investment Grade Emerging Market Bond Index and USD High Yield Emerging Market Bond Index. To be included in the index a security must have a minimum par amount of 100MM.
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

The MSCI EM (Emerging Markets) Latin America Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of emerging markets in Latin America. The MSCI EM Latin America Index consists of the following 5 emerging market country indices: Brazil, Chile, Colombia, Mexico, and Peru*.

Morgan Stanley Capital International EAFE Index (MSCI EAFE), an unmanaged index, is compiled from a composite of securities markets of Europe, Australasia and the Far East.

The Dow Jones-UBS Commodity Index℠ is composed of commodities traded on U.S. exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metal Exchange (LME).

The U.S. Dollar Index (DXY) measures the dollar's value against a trade-weighted basket of six major currencies.

It is not possible to invest in an index.

Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution and involve investment risks including possible loss of principal and fluctuation in value.

Brokerage, investment and financial advisory services are made available through Ameriprise Financial Services, Inc. Member FINRA and SIPC.

© 2013 Ameriprise Financial, Inc. All rights reserved